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ACCOUNTING 

AND THE 


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University of Florida Libraries 
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Gift of 

Potter, Bower & Company 
Certified Public Accountants 




CERTIFIED FVBLIC ACCOVNTANTS 
ORLANDO, FLORIDA 



THE IRWIN SERIES IN ACCOUNTING 



Consulting Editor 
WILLARD J. GRAHAM, Ph.D., C.P.A. 

University of North Carolina 



BOOKS IN THE IRWIN SERIES IN ACCOUNTING 

Holmes, Maynard, Edwards, and Meier 

ELEMENTARY ACCOUNTING 

INTERMEDIATE ACCOUNTING 

Holmes and Meier 

ADVANCED ACCOUNTING 

Neuner 

COST ACCOUNTING: Principles and Practice 

Holmes 

AUDITING: Principles and Procedure 

BASIC AUDITING PRINCIPLES 

Holmes and Moore 

AUDIT PRACTICE CASE 

Kennedy and Mc Mullen 

FINANCIAL STATEMENTS 

Anderson and Schmidt 

PRACTICAL CONTROLLERSHIP 

Hill and Gordon 

ACCOUNTING: A MANAGEMENT APPROACH 

Mikesell and Hay 

GOVERNMENTAL ACCOUNTING 

Schmidt and Bergstrom 

FUNDAMENTAL ACCOUNTING 

Meigs 

PRINCIPLES OF AUDITING 

Grinaker and Seller 

AUDIT PRACTICE CASE 

Pyle and White 

FUNDAMENTAL ACCOUNTING PRINCIPLES 

Anthony 

MANAGEMENT ACCOUNTING: Text and Cases 

Shillinglaw 

COST ACCOUNTING: ANALYSIS AND CONTROL 

Moore and Stettler 

ACCOUNTING SYSTEMS FOR MANAGEMENT CONTROL 

Murphy 

AUDITING AND THEORY: A CPA REVIEW 

Ladd 

CONTEMPORARY CORPORATE ACCOUNTING 

AND THE PUBLIC 



L^ on temp or a ru 
Corpora te — ^rccoun Una 

and 
tke l^ubllc 



CONTEMPORARY 

CORPORATE 

ACCOUNTING AND 

THE PUBLIC 

</ 3 -/T3Z2-. 
By DWIGHT R. LADD, D.B.A. 

Professor of Business Administration 
University of Western Ontario 




1963 

RICHARD D. IRWIN, INC, 

HOMEWOOD, ILLINOIS 



© 1963 BY RICHARD D. IRWIN, INC. 

ALL RIGHTS RESERVED. THIS BOOK OR ANY PART THEREOF MAY NOT BE 
REPRODUCED WITHOUT THE WRITTEN PERMISSION OF THE PUBLISHER 



First Printing, August, 1963 



Library of Congress Catalog Card No. 63-19882 

PRINTED IN THE UNITED STATES OF AMERICA 






For Betty 
and for Bob, Kathy, and John 



FOREWORD 

This book rests upon two propositions. The first is that the 
large modern corporation has become a major repository of 
economic and social power— power which must be used in the 
interests of society. Thus it is of utmost importance to society 
that it know and understand the extent and the uses of this 
power. (I do not suggest that this power has been gathered in 
the corporation by intent or design; indeed its existence is per- 
haps not always recognized by those who hold it.) 

The second proposition is that accounting is a principal 
means (which is not to say sole means) of communication about 
the affairs of corporations to those outside the corporations who 
are concerned with these affairs. Thus accounting has the vital 
social role of passing on to the public, information about the ex- 
tent and uses of corporate powers. 

The purpose of the book is implicit in these propositions. 
It is an examination of the extent to which the conventions and 
procedures of contemporary accounting are compatible with its 
vital social role. Its basic concerns are first, with the question, 
"Why account?" and flowing from that with the question, 
"What to account for?" Concern with "How to account?" is 
essentially incidental. Any human activity seems to require an 
occasional reconsideration of its raison d'etre, for we seem able 
to make regular adjustments in procedural details without 
seriously reviewing the broad objectives which underlie the 
procedures. Because of the great changes in the nature and the 
role of the corporations being accounted for, I believe that ac- 
counting has a great need for such a reappraisal now. 

In the discussions which follow, I will recommend certain 
changes in definitions, conventions, and procedures, and I wish 
to acknowledge that some of these may be beyond the limits of 
practicability at the present time. However, I think this is less 
a matter of technology than of attitude. Our ability to answer 

ix 



FOREWORD 

difficult questions and to solve difficult problems has been in- 
creasing and continues to increase at a phenomenal pace. The 
basic constraint here is in our ability to ask questions and to 
state problems. I will suggest here some different approaches to 
accounting for large corporations which will require information 
not now readily available. I believe, however, that if the ques- 
tions are asked it is highly likely that they can be answered. 
Furthermore, I believe that asking the questions is the important 
thing. 

Accounting is a completely derived art and what it does 
and how it does it must be derived from the needs of those at 
either end of the chain of accountability. These needs have been 
and are changing with astonishing rapidity; accounting has not. 
Whether accounting makes the specific changes in concepts 
and procedures recommended here is of less importance than 
that it change. What follows is given in the interests of the 
greater flexibility needed to meet rapid economic and social 
change. It is not my desire to substitute new dogma for old. 



My wife has sometimes wondered aloud about the amount 
of time which professors spend in talking— especially when the 
talking carries on past the normal dinner hour. Well, one thing 
that we sometimes achieve by our talks is to stimulate the writing 
of books, and this book is the result, above all else, of talking 
with a great many people about the problems of the social role 
of large corporations and of accounting for them. (I do not 
imply that the book will stand as ultimate justification of pro- 
fessional talking.) Consequently, it is appropriate that I acknowl- 
edge that in preparing this book, I have been helped by virtually 
everyone with whom I have talked about these matters. My debt 
is on a grand scale and much is owed to many who will disagree 
with much that I have written. 

A very special acknowledgement must be made to several 
hundred students who have sat in my classes over the several 



FOREWORD 

years during which my ideas have been forming. They have 
always been a very effective sounding board for these ideas, and 
on the whole, I think, a patient one. Their forthright criticism 
of my ideas and careful propounding of rebuttals have both 
contributed much to this book. 

Beyond all these, there are persons whose willingness to 
criticize has been the source of great help and whose readiness 
to encourage, the source of much satisfaction. From my father- 
in-law, Royal C. Nemiah, has come constant intellectual stimula- 
tion which I acknowledge with affection. Officially he is a Pro- 
fessor of Greek, but in the tradition of great teachers, he has al- 
ways taught students rather than subjects. Though by marriage 
rather than by matriculation, I have long been one of his students 
and in many discussions about our society and the role of busi- 
ness in it, he has helped me shape many of my ideas— quite often 
by disagreeing with me. 

Professor Ross Graham Walker, of the Harvard Business 
School, my friend and teacher for over fifteen years, has exam- 
ined parts of the manuscript and once again has given me the 
benefit of his tremendous insights into all matters relating to 
business. Mr. W. H. Ferry, of the Center for the Study of 
Democratic Institutions, encouraged me to proceed with this 
writing when it was little more than a half-formed idea and 
was quick to encourage again when, as it must, the going be- 
came rough. My colleagues, Professors John T. Nicholson and 
C. Kennedy May at the University of Western Ontario, and 
Mr. John H. McArthur at IMEDE in Lausanne, Switzerland, 
have given me more time and attention over many questions 
and problems than I have deserved. Indeed, Professor Nicholson, 
in spite of writing problems of his own, has at times, been indis- 
pensible to me. The detailed criticisms of Professor Willard J. 
Graham of the University of North Carolina have been of 
immeasurable help— especially in connection with Chapters 
Seven and Eight. My secretary, Mrs. Clara Black, has with hard 
work and uncommon patience, typed and retyped and relieved 
me of many chores of manuscript preparation. 

xi 



FOREWORD 

How bachelors write books, I do not know. Without my 
wife's readiness to make things easy for me in the many little 
ways that wives know about and above all, without her unfailing 
understanding of when I needed to be encouraged and when I 
needed to be pushed, this book would never have been written. 

In spite of all this help, the pleasure of writing has, happily, 
been mine alone, as must be the responsibility for what has been 
written. 



Dwight R. Ladd 



1962 
London, Canada 



XI i 



TABLE OF CONTENTS 



CHAPTER PAGE 

One. Introduction 1 

The Plan of the Book. 

Two. The Corporation, Its Reponsibilities, and 

Accounting 9 

Three. Corporation Objectives and Accounting 18 

Four. Comparability in Corporation Reports 25 

Uniformity in Accounting Procedure. 
Changing Price Levels. Summary. 

Five. The Procedural Bases of Accounting 38 

Consistency. Materiality. Money. Permanence. Income 
Taxation. Past and Future. 

Six. Value and Capital 50 

Monetary. Purchasing Power. Productive Capacity. 

Seven. Inventory Accounting 63 

Specific Identification. First-In, First-Out. Average Cost. 
Last-In, First-Out. LIFO and Income Taxation. 

Eight. Accounting for Fixed Assets 77 

Replacement Cost. Decline in Value. Depreciation Accounting. 
Deferred Taxes. Accounting for Leased Fixed Assets: The 
Accounting Problems. Accounting for Natural Resources. 
Summary. 

Nine. Complex Business Combinations 106 

Holding-company Statements. Conditions for Consolidation. 
Accounting for Mergers. Pooling of Interests. 

Ten. Compensation 123 

Accounting for Pension Plans: Basic Characteristics. The Ac- 
counting Problems. Stock Options: Characteristics of Stock 
Options. Definition of Cost. Determination of Cost. Grant Date. 
Date Exercised. Annual Deductions. Market Value. Disclosure. 

Eleven. Intangible Resources 142 

Contemporary Accounting Procedures: Resource Valuation. 
Income Determination. The Rationale of Accounting Pro- 
cedures: Discrimination. 

Twelve. Responsibility for Accounting: A Summing Up . . 158 
Authority of Management. 

Index 171 



xni 



L^kapter K-Jne 



T 



INTRODUCTION 



i 

It was probably about 5,000 years ago in some dusty town 
in the Tigris-Euphrates valley that a merchant or a land specu- 
lator first undertook to use in his business the resources of some- 
one not directly involved in that business. At such a moment, 
when an outsider first acquired an interest in a business and the 
business first accepted a responsibility to the outsider, accounting 
must have begun. When the outsider entrusted responsibility for 
some of his resources and some of his welfare to the business 
with which he was not directly involved, a need arose for in- 
formation about how the responsibility was being met. This 
provision of information about the status and progress of a 
business to properly interested outsiders has, from that day to 
this, been a primary function of accounting. 

As the nature of business and its relationship with outsiders 
has changed and evolved, accounting has had to change and 
evolve in order to continue to meet its responsibility for pro- 
viding those who have a proper interest in a business with re- 
liable and adequate information about the business. Particularly 
as the responsibilities of the business become more widespread 
and as the business becomes more remote from those to whom 
it is responsible, the greater the need becomes for information 
on which to base evaluations. Furthermore, such changes re- 
quire constant consideration of the extent to which changes 
in the conceptual and procedural bases for preparing and dis- 
seminating information are necessary. 



Contemporary Corporate Accounting and the Public 

It can be said with assurance that accounting does change 
constantly. However, it can also be said that changes which have 
taken place have, to a large extent, been introspective in the 
sense that they have resulted from reappraisals of how certain 
accepted objectives could best be met rather than from question- 
ing the relevance of the objectives themselves. Accounting has 
not kept pace with the marked changes which have taken place 
during the past quarter century or so in the role of business— 
especially large corporations, the concern of this book— in our 
society. What A. A. Berle, Jr., has called The Twentieth Cen- 
tury Capitalist Revolution 1 has resulted in a new orientation of 
business responsibilities and new concepts of appropriate business 
activities and objectives. It seems clear, for example, that satis- 
faction of the stockholder interest in corporations is no longer 
the sole or even the primary responsibility of corporation man- 
agers; yet to a considerable extent accounting concepts and 
procedures are firmly based on the premise of the paramountcy 
of the ownership interest. It is perhaps not so clear, but it surely 
can be argued, that corporations have turned toward main- 
tenance of competitive position, growth, and "good citizenship" 
and away from maximum profit as their major objective; yet 
accounting is tightly tied to the assumption that maximum profit, 
achieved in an essentially short run, is the primary objective of 
the corporation. These and other responsibilities and objectives 
of contemporary large corporations provide both the starting 
point and the continuing background for this discussion of the 
present-day practice of accounting. 



'Professor A. A. Berle, Jr., whom I have never met, has some responsibility 
for this book since his many writings on the subject have, for a number of 
years, kept me thinking about these matters. Among his books on this subject 
are: The Modern Corporation and Private Property (with Gardiner C. Means) 
(New York: Macmillan Co., 1932); The Twentieth Century Capitalist Revolu- 
tion (New York: Harcourt, Brace, 1954); Economic Power and the Free So- 
ciety (Santa Barbara, Calif.: Center for the Study of Democratic Institutions, 
1957). In addition Professor Berle has contributed the preface to a most timely 
and important symposium, The Corporation in Modern Society, E. S. Mason, 
ed. (Cambridge, Mass.: Harvard University Press, 1960). 



INTRODUCTION 

II 

In America the corporation has developed as the principal 
instrument for the utilization of human, material, and monetary 
resources in the production and distribution of goods and serv- 
ices and for rewarding those who provide these resources. Since 
ours is a society overwhelmingly concerned with the production 
and distribution of goods and services it is not surprising that 
the corporation has become the very center of our social and 
economic existence. 

The corporation is, in law, the "person" who owns or con- 
trols and uses the resources and rewards those who provide 
them, and thus it is common to speak of corporate activities, of 
corporate responsibilities, of accounting for the corporations. 
In fact, it is the managers and directors of the corporation ("the 
management group") who make the decisions and direct the 
activities of the corporation, who hold, in the short run, the 
powers of the corporation. Furthermore, since these men for the 
most part provide for their own succession, they actually hold 
the powers of the corporation indefinitely. Consequently it 
would be most appropriate to speak of management activities, of 
management responsibilities, of accounting for management. 
However, managers always act in the name of and on behalf of 
the corporations: they represent the corporation, but it never 
represents them. Furthermore, the corporation (General Motors, 
U. S. Steel, AT&T, etc.) rather than the men who manage it, 
is what most of us readily comprehend. Consequently, the phrase 
"accounting for corporations" will generally be used here, even 
though it is recognized that it is ultimately the actions of the 
management group which are being accounted for. 



Essentially this book is concerned with two questions. To 
what extent should corporations inform properly interested 
persons outside the management group about their affairs? What 
should be the conceptual and procedural bases for passing on 
such information? While the corporate image makers have 



Contemporary Corporate Accounting and the Public 

lately involved themselves with these matters, such communi- 
cations remain in large part the special function of accounting. 
Therefore, this is a book about accounting, though it is not 
concerned with the procedures and conventions of bookkeeping 
and statement preparation nor with the collection and process- 
ing of accounting data. The reader is assumed to have a working 
knowledge of the basic ideas and procedures of accounting 
but not the expertise of the trained accountant. Nor is this 
book an attempt to provide that expertise. No "answers" to 
the technical problems which are daily faced by the practicing 
accountant or the student will be found here. Indeed, some 
questions are raised without answers attempted because this book 
is only incidentally concerned with "how to account." Its con- 
cern is with "why account" and, flowing from that, "what to 
account for." 

The general structure and certain specific applications of 
contemporary accounting theory and practice have been con- 
sidered in terms of a specific view of the broad economic and 
social role and objectives of the corporations being accounted 
for. This view of corporate role and objectives, described in 
the following chapter, and the accounting requirements which 
flow from them is central to all that follows. Indeed, much 
of what is said here will have only limited relevance to an- 
other view of the role of the corporation and of accounting 
for it. This coverage of specific problem areas is not exhaustive 
but represents a personal and arbitrary selection. Nonetheless, 
the topics discussed are quite representative and are, by any 
standard, of first-rank importance. 

At the risk of irritating the professional who may come upon 
this book, technical language and jargon are avoided as far as 
possible as are those operational matters and relatively minor 
points which so fascinate the expert. Given the great influence of 
corporations in our society, the need for information about 
their activities and the ability to understand the significance of 
that information are of concern to all intelligent citizens. The 
problem is of too great importance to permit it to remain ob- 
scured by the niceties of discussion among experts. 



INTRODUCTION 

IV 
THE PLAN OF THE BOOK 

A consideration of the two questions posed above requires 
some prior discussion of who are "properly interested outsiders," 
of corporate responsibilities to those outsiders, and of the nature 
of corporate "affairs." The following chapter includes a review 
of some current thinking about the role and responsibilities of 
the modern corporation and the requirements for some degree 
of broad social control which flow both from the great power 
implicit in that role and from the great scope of these responsi- 
bilities. The chapter also includes a brief sketch of the role 
of accounting in such a control mechanism. 

In Chapter Three the apparent shift in corporation objectives 
from profit maximization to maintenance of competitive position, 
growth, and "good citizenship" is discussed and the implications 
of this shift for accounting are considered. Accounting is the 
principal instrument for communication between the corpora- 
tion and its constituencies and the way the instrument is used 
must conform to the relationship between and activities of those 
at either end of the channel of communication. 

If accounting is to communicate about corporate affairs 
with any effectiveness there must be some degree of uniformity 
and comparability among corporation reports. At the present 
time, much of the usefulness of corporation reports is destroyed 
by lack of uniformity in accounting methods, by failure to 
indicate methods used, and by failure to make explicit provision 
for changing monetary values. The arguments for and against 
uniform methods and price-level adjustments are reviewed in 
Chapter Four. 

Accounting is a system of measurement as well as a means 
of communication, and thus any discussion of accounting must 
concern what is being measured and measurement procedures. 
These latter are the subject of Chapter Five in which the basic 
conventions which underlie all accounting measurements and 
communications are reviewed. It is almost universally agreed 
that accounting is concerned with measuring the amounts of 



Contemporary Corporate Accounting and the Public 

and changes in corporate capital, but there is considerably less 
agreement about the precise nature of corporate capital. The 
definition of corporate capital is the subject of Chapter Six. 

The balance of the book, excepting the last chapter, is con- 
cerned with several specific problem areas in which the concepts 
and procedures discussed in the preceding chapters are of par- 
ticular importance. The extreme changes in the value of money 
in the past twenty years and the apparent changes in the basic 
objectives of the corporations have created particular difficulties 
in accounting for resources held by corporations over consider- 
able periods of time, among which inventories and plant and 
equipment are the most prominent. The several aspects of ac- 
counting for these resources are discussed in Chapters Seven and 
Eight respectively. Accounting for inventories has been further 
complicated by "direct costing," a technique developed in re- 
sponse to the need for more sophisticated data for internal 
decision making. In the case of plant and equipment, a relatively 
new difficulty resulting from the increasing tendency to lease 
rather than to purchase is also discussed. The chapter also in- 
cludes a discussion of accounting for so-called wasting resources. 

Chapter Nine is concerned with the ever-increasing scope of 
corporations' activities and their increasing tendency to cut 
across traditional industry boundaries. Automobile companies 
manufacture locomotives and waffle irons. Chemical companies 
manufacture ethical drugs. An abrasives and adhesives company 
makes recording and reproducing equipment. Virtually all manu- 
facturing companies are involved in making missiles or other 
military equipment for the armed forces. Because of its con- 
centration on the interests of ownership and the stockholder, 
accounting has not developed procedures for reporting ade- 
quately on these widespread and frequently unrelated activities 
of corporations. Simultaneously, it is often desirable to ignore 
in accounting the economic artificialities created by forms of 
organization which result in the parts of an essentially integrated 
whole being legally separated into discrete units. 

Two somewhat related accoutrements of the present-day 
corporation— pensions and stock options— have given rise to im- 



INTRODUCTION 

portant accounting problems which have not yet been resolved 
but whose resolution is of extreme importance in terms of the 
use of accounting reports as a means for broad evaluation of 
corporations' performance. These are the subjects of Chapter 
Ten. 

Chapter Eleven is concerned with intangible resources in 
general and in particular with such things as advertising and 
promotion and research and development— things which seem 
in large part a function of the shift to maintenance of competi- 
tive position and growth as the foremost corporation objectives. 
To date accounting has failed to recognize the tremendously 
increased magnitude of these elements of corporations' activity 
compared with their scope fifteen or even ten years ago. These 
are, nonetheless, the areas of corporations' activity where the 
public interest and concern are most apparent and direct, and 
therefore accounting for them must be improved. 

Finally, in Chapter Twelve, the process of developing and 
instituting changes in accounting concepts and procedures is 
considered. It will be suggested that many of the problems dis- 
cussed previously result from the fact that there is no clearly 
defined locus of responsibility for developing accounting con- 
cepts and practices, nor is there any recognized authority for 
enforcing discipline within that heterogeneous group of people 
in business, government, and education which makes up what 
is loosely called the accounting profession. To a very great de- 
gree, accounting is largely controlled by the very people whose 
activities are being accounted for. 



The foregoing are, in outline, the specific topics which will 
be discussed in this book. The list is not claimed to be compre- 
hensive, but most of the major problems of contemporary ac- 
counting are considered. Furthermore, the coverage need only 
be broad enough to demonstrate the gap which exists between 
the needs of society for information about our large corporations 
and the quantity and quality of information being provided by 



■^^^■fln 



Contemporary Corporate Accounting and the Public 

contemporary accounting. This book is concerned with creating 
an awareness of that gap and with contributing to its being 
narrowed. Changes suggested in connection with the problems 
discussed here are, in general terms, applicable to other problems. 



l^kapter ^Ji 



wo 



THE CORPORATION, ITS 

RESPONSIBILITIES, AND 

ACCOUNTING 



i 

Accounting in all its scope is concerned with all business 
large and small and with many nonbusiness organizations. This 
book is concerned only with accounting for "big business" 
because the great need of the community for information (and 
thus for accounting) is created by the very bigness of big busi- 
ness. Whether one takes fortune's "Five Hundred" or the "Two 
Hundred" of Berle and Means or another of several such reckon- 
ings 1 it is certain that a relatively small group of large or 
otherwise important corporations dominate our economy in 
the broadest sense, and in diverse other ways exert a profound 
influence on the lives of us all. Indeed it seems clear that these 
corporations have become second only to government (and 
perhaps equal with government) as the major locus of power, 
employed or latent, in our society. Furthermore, one must be 
aware of the possibility that the military arm of the government 
and the military supply section of business may together be our 
major power center. (We were forcefully reminded of this possi- 
bility and the dangers inherent in it by former President Eisen- 
hower in his last address before leaving office; an address which 



a An up-to-date summary of the concentration of business power is con- 
tained in Carl Kaysen, "The Corporation: How Much Power? What Scope?' 1 
E. S. Mason (ed.), The Corporation in Modern Society (Cambridge, Mass.: 
Harvard University Press, 1960), Chap. 5. 



Contemporary Corporate Accounting and the Public 

may well have been his most important, though largely neg- 
lected, public utterance.) At any place and at any time there is 
an obvious need for accounting for such concentrations of 
power in the interests of the preservation of freedom. Beyond 
this general case two specific conditions, arising from our own 
place and time, make essential the availability of information 
about the status and affairs of these corporations. 

The first of these conditions relates to our struggle with the 
Soviet Union and its allies— both the obvious and direct conflict 
in such places as Berlin and Viet Nam and the competition to 
gain the adherence of the new and underdeveloped nations. In 
this struggle the conduct of American business and its personnel 
is, willy-nilly, a major factor. Trade among nations in the 
products of business is a crucial element. Both these facts make 
business an instrument of national policy, and if the instrument 
is to be used effectively in the national interest the nation must 
know what it is doing. 

The second condition may be called the cybernetic revolu- 
tion which is well on its way to taking over from the capitalist 
revolution. That the work of industry— indeed, the direction of 
much of that work— will increasingly be done by machines is no 
longer a matter for speculation. We are now realizing some 
of the implications of this revolution 2 , and there is no doubt that 
both during the transition to automated industry and after, con- 
trol of business— the agency through which this revolution is 
(fk being carried out— is required by the pubhc^intexest. 

It is neither assumed nor desired that we will abandon our 
system of private direction of enterprise in favor of a state- 
directed system. In our present setup, the power of decision 
rests in the hands of the managers of corporations except in 
areas specifically circumscribed by law or custom, and this seems 
unlikely to change in the foreseeable future. Given the fact that 
these corporations have enormous power in our society, there 
must be a basis for a review of decisions even though the power 
of decision remains within the corporation. It is a major func - 



2 See, for example, W. H. Ferry, Caught on the Horn of Flenty (Santa 
Barbara, Calif.: Center for the Study of Democratic Institutions, 1962). 

10 



CORPORATION, RESPONSIBILITIES, ACCOUNTING 

tion of accounting to provide the information on which to I 
base such reviews. 3 



II 

An important task of accounting is to provide to properly 
concerned persons outside the management group information 
about the status and probable progress of the corporation. It is 
typically contended that this task involves making "an inde- 
pendent appraisal of the fairness of reported results of manage- 
ments' stewardship as shown in annual financial statements made 
available to shareholders. Fairly stated financial statements re- 
sult not only from dependable recording and summarization of 
financial transactions, but also from proper application of gen- 
erally accepted principles of accounting." 4 

This view of the role of accounting well fits that part of 
our tradition which holds that corporation managements are 
ultimately responsible to the owners of the corporation— the 
stockholder. Some corporate annual reports still use the second 
person, reciting to the stockholder the achievements of "your 
company," "your management," "your factories." The ritual of 
the annual stockholders' meeting, complete with box lunches 
and Lewis D. Gilbert, is the symbol of this tradition. On a more 
important level, one finds that much of the theory of investment 
within the individual business is firmly anchored to this tradition. 

For some time, however, there have been many indications 
that the tradition is no longer a relevant description of corporate 
responsibilities (if, indeed, it ever was). Probably starting in 
1932 with Berle and Means's The Modern Corporation and 
Private Property, there has been an ever-increasing articulation 



3 If it is true that we are to fight a long "war" with the Soviet Union, utilizing 
economic rather than military weapons, we may well be forced into increased 
state direction of enterprise for businesses may be our principal "fighting" or- 
ganizations in such a war. It is, after all, a long time since Western nations have 
looked to private enterprise to organize and direct their military forces, and 
the ineffectiveness of such private-enterprise armies (as in Nationalist China) 
against state-directed forces is apparent. 

4 N. J. Lenhart and P. L. Defliese, Montgo?nery''s Auditing (8th ed.; New 
York: Ronald Press, 1957). 

11 



Contemporary Corporate Accounting and the Public 

of the view that corporate responsibility is far more widespread. 
Many proponents of these views have been corporation managers 
themselves; the idea of broad corporate responsibilities is not 
exclusively the idea of critics of the corporation. This broad 
view of the corporation's responsibility is well summarized in 
this statement (typical of many) of the late Louis D. Brown, 
one-time chairman of the Johns-Manville Corporation: 

In the evaluation of a complex industrial society the social re- 
sponsibility of management has broadened correspondingly. Manage- 
ment no longer represents, as it once did, merely the single interests 
of ownership; it increasingly functions on the basis of a trusteeship 
which endeavours to maintain, between the four basic interlocking 
groups, a proper balance of equity. Today the executive head of 
every business is accountable not only to his stockholders but to 
members of his working organization, to his customers, and to the 
public. 5 

Taken literally, the foregoing suggests for the corporation 
a most awesome social role. The maintenance of "a proper 
balance of equity" among virtually all elements of society would 
seem to require the assumption by corporations of much of 
the traditional roles of government, of educational institutions, 
of the church. The parallel with feudalism is remarkably close 
for that system was characterized by the acceptance by the 
seigneur of the obligation to maintain a balance of equity among 
the elements of the society. Apparently, no one has yet sug- 
gested that the several corporate constituencies should give 
fealty to the corporation executive as the constituencies of the 
seigneury gave fealty to the seigneur, but this seems a not-illogi- 
cal extension of the idea expressed above. 

Even if taken less literally, Mr. Brown's statement indicates 
very clearly the downgrading of the stockholder interest in 
corporations which has taken place. It is not now, if it ever was, 
the paramount interest, but is at best coequal with the interests 
of a whole congeries of constituencies or publics. Corporation 
managements are responsible to many besides the stockholders, 



°Quoted by Howard R. Bowen in Social Responsibilities of the Business- 
man (New York: Harper, 1953). 

12 



CORPORATION, RESPONSIBILITIES, ACCOUNTING 

and therefore accounting reports on the "results of manage- 
ment's stewardship" should be conceived of as far more than 
reports to shareholders alone. 

Before leaving the question of responsibility it is important 
to recognize that there is surely one more than the "four basic 
interlocking groups" Louis Brown recognizes. Management itself 
is an important part of the corporate complex, with rights, de- 
sires, aspirations, and its own needs for equity. Managers would 
not be human if, in their attempts to reconcile the interests of 
the other constituencies of the corporation, they did not, im- 
plicitly at least, consider their own interests. The tradition that 
management is accounting for itself to shareholders puts man- 
agement in the unsatisfactory position of passing judgment on 
its own definition of its own interests and on the way it has 
satisfied those interests. The position of contemporary manage- 
ment needs to be given legitimacy. 

Virtually all segments of the community, including corpora- 
tion managers, have come to have important interests in the 
status and progress of the large corporation, which is by way of 
saying that the corporation has important responsibilities to all 
of them. These responsibilities are a function of the corporation's 
role as our principal instrument for the utilization of human, 
material, and monetary resources in the production and distribu- 
tion of goods and services, and for rewarding those who provide 
these goods and services. Since the supply of virtually all these 
resources is less than the demand for them over the long run, 
it is in the interest of the community— and thus a responsibility 
of the corporation— that they be used efficiently and rationed 
according to need. Since the rewards are generally made from 
the same stock of resources, it is in the community interest and 
a responsibility of the corporation that the rewards be equitable 
and be socially and economically efficient. 

All of the following discussions of accounting concepts and 
procedures are based on the foregoing definition of the corpora- 
tion's responsibility, and it is assumed that this responsibility 
is owed to several constituencies— stockholders, management, 
workers, customers, suppliers, and the public. 

13 



Contemporary Corporate Accounting and the Public 
III 

Any system of responsibility involves a degree of control 
over those who are responsible by those to whom they are 
responsible. A control system may be incredibly complex, but 
it will always include three basic elments: a standard of per- 
formance for the controlled organization, a mechanism through 
which the controller receives necessary information about the 
performance of the organization, and a process by which the 
controller can command the organization to adjust its perform- 
ance. This book is specifically concerned with the second of 
these elements— information. The nature of the command mecha- 
nism is beyond its scope although, in passing, it appeared dur- 
ing such events of recent history as the steel-price affair and 
the drug-inspection law that ready access to the several media 
of publicity can be extremely efficacious command mechanisms. 
I Objective or standard of performance can be readily defined as 
J safeguarding the public i nterest, though this definition probably 
raises more questions than it answers since the nature of the 
public interest will depend upon specific conditions at specific 
times. For purposes of these discussions, "the public interest" 
has been defined in terms of the efficient and equitable use of 
the resources the corporation controls. 

Whether more formal standards and command mechanisms 
are one day instituted or whether we rely on informal, ad hoc 
agencies, the control process will essentially rest upon the ability 
of those outside the management group to ask informed and 
intelligent questions and to suggest change and improvement 
where the answers indicate the need. The crucial element in 
this process is the basis for asking questions: complete and re- 
liable information about the corporation's progress, status, and 
plans. That the information needed goes beyond the financial 
information which is the particular province of accounting is 
obvious. Nevertheless, a very great deal of what corporations 
do and do not do is expressed in financial terms and financial 
data make up the important nucleus of needed information. 

The basis of the corporation's responsibility as it has been 

14 



CORPORATION, RESPONSIBILITIES, ACCOUNTING 

defined here (and indeed, the basis of the powers of the corpora- 
tion) is its control of resources. Consequently, control over the 
way in which the power is used and the responsibilities are met 
begins with the possession and evaluation of information about 
these resources by those affected by their use. In general terms, 
this process of evaluation involves answering two sets of ques- 
tions. The first and most important set concerns the present and 
the future. 

1. What resources does the corporation control and what obli- 
gations has it incurred in obtaining control of them? 

2. What is the value of these resources? 

3. What are the commitments or plans for the use of these re- 
sources in the future? 

4. What is expected to result from these planned uses? 

The second set of questions is of secondary importance, re- 
lating as it does to the past. 

5. What resources did the corporation acquire since the last 
accounting? 

6. Where did these resources come from? 

7. What were the results achieved by the use of the resources 
on hand at the last accounting? 

Much of the remainder of this book is a discussion of the 
extent and the relevance of the information generally available 
for answering these several questions. At this point, however, 
certain general prescriptions for such information can be stated. 
In the first place, the information must be related to the present 
and to the future, not to the past. Once a decision has been 
made and resources committed, congratulation or recrimination 
—depending upon the outcome of the act— are about the only 
possible courses of action. While it is far, far easier, in general, 
to hold post-mortems than it is to make prognoses, the only 
real value of the post-mortem is that it may lead to better prog- 
noses in the future by indicating errors in past ones. The im- 
portant task— and often an incredibly difficult one— is to analyze 
the probable results of contemplated future actions. Until a 
decision is actually implemented it is always possible to change 
plans and accept the opportunity of using resources elsewhere. 

15 



Contemporary Corporate Accounting and the Public 

In the second place, information must be basically complete. 
Ideally, all the resources in the possession of or under the control 
of the corporation must be known, and all the commitments of 
resources must be known. What can, in fact, be known will be 
limited by inevitable uncertainty about the future and by the 
availability of time and money for obtaining information. The 
position of one attempting to evaluate the use of resources by a 
corporation without complete information is rather like that 
of the ship's navigator who is unaware of the unseen portion of 
the iceberg his ship is approaching. 

Finally, the information must be understandable. Obviously 
the facts surrounding the control and use of a wide range of 
resources by corporations are not simple and understanding 
them requires a degree of knowledge and effort on the part of 
the reader or listener. This requirement, however, should not 
be a convenient excuse for confused terminology and for failure 
to explain adequately how certain important figures were de- 
termined. And since the information is used in the evaluation 
of many corporations, being understandable requires a suitable 
degree of comparability or uniformity among the statements 
and reports of all corporations. 

In summary, the information required to effectively evalu- 
ate corporations must be as complete as possible. It must be 
relevant to the future, within the limits of tolerable uncertainty, 
and it must be understandable and comparable. 

At the present time, the persons, organizations, concepts, and 
procedures which together comprise what is usually called 
financial accounting are the principal mechanism by which this 
sort of information about corporations is made available. In 
general, the information currently available from this source is 
almost exclusively concerned with the past; it is rarely complete 
and is neither sufficiently understandable nor comparable. How- 
ever, this does not mean there is need for a new mechanism, if 
for no other reason than that the pool of highly skilled and de- 
voted personnel and a host of important and effective processes 
and relationships are virtually irreplaceable. Basically, the only 
requirement is for_a_r edefinition ofjpurpose, a rededication to 

16 



CORPORATION, RESPONSIBILITIES, ACCOUNTING 

the well-established maxim of accounting that the uses to which 
information is to be put should govern both the conceptual and 
procedural bases on which the information is prepared and 
disseminated. In the past quarter century, the over-riding re- 
sponsibility of our large corporations has become not to stock- 
holders alone but to a whole congeries of constituencies which 
is, in fact, our society. Thus accounting information is, or should 
be, used by the community at large, but because accounting has 
not recognized this, the information is frequently not relevant 
to these uses. 



17 



L^nupter *Jhree 



CORPORATION OBJECTIVES 
AND ACCOUNTING 



For many years now, accountants have given the bulk of 
their attention to the measurement of annual income. Professor 
Moonitz, in the first Accounting Research Study, refers to the 
" central position that income determination has and does occupy 
in accounting." Concepts of income have been much debated 
and the ultimate criterion in evaluating proposed changes or 
new developments in accounting procedures has been "effect 
upon income." Corporate net-income figures are widely publi- 
cized and all sorts of judgments about dividends, stock prices, 
wages, prices, contributions, management efficiency, and so on 
are based upon them. 

Since accounting is presumably derived from the activities 
and needs of those at either end of the chain of accountability 
and since accounting places so much emphasis on measuring and 
reporting annual net income one might reasonably conclude that 
the achievement of maximum annual net income is the principal 
objective of corporation managers. Further, one could con- 
clude that those to whom the managers are responsible are pri- 
marily concerned with management's effectiveness in achieving 
maximum annual income. Actually, ther e are many indicat ions 
that corporate survival and growth (in the long run the two 
are the same) are the p rincipal objectives _o f contemporary 
corporations and that these objectives are implicity accepted by 
most of those to whom the corporations are responsible. 

The mystique of unlimited potential which characterized 

18 



CORPORATION OBJECTIVES AND ACCOUNTING 

America through the nineteenth century and the first two 
decades of the twentieth seemed virtually obliterated by the de- 
pression psychosis, to use Professor Galbraith's words, which 
was the legacy of the early 1930's. During the late 1950's and the 
1960's, however, the possibility and desirability of growth 
seemed restored to its former position as one of the major articles 
of the American faith— especially so since the Russians began 
to publicize their own growth. The debate about desirable rates 
of economic growth and how to obtain them filled a major 
place in the 1960 presidential campaign. A recent study of the 
causes of growth in companies states in its introduction: 

Granted that a successful business future comes neither auto- 
matically nor easily, is its provision chiefly a laudable management 
maxim, or really a practical primary responsibility? Compounding 
the magnitude of the assignment is the nearly universal desire for 
something considerably better than mere corporate perpetuation— 
a task difficult in a rapidly changing business world. 

The demands for "growth" are incessant. And the label "growth 
firm" has become increasingly synonymous with success, seemingly 
replacing "blue chip" as the corporate status symbol of the nine- 
teen sixties. 1 

The desire for growth may, of course, be nothing more than 
an essentially defensive reaction to an ever-increasing population 
with the resultant ever-increasing work force. Surely the con- 
tinued development and expansion of so-called automation spur 
growth and attempts to grow, because in a great many cases 
automation is practical in only fairly large units. (Automation, 
as it displaces workers, also adds to the available work force.) 
The increasing mechanization of data processing together with 
developments in communications generally have fostered growth 
by increasing the capacity of individual managers to manage. 
Data for decision making are available in time periods whose 
brevity was undreamed of twenty years ago, and analyses of 
problems may now be made with levels of sophistication barely 
contemplated until very recently. 



Robert B. Young, "Keys to Corporate Growth," Harvard Business Re- 
view, Vol. 39, No. 60 (Nov.-Dec, 1961). 

19 



ra 



Contemporary Corporate Accounting and the Public 

In addition to all these essentially external forces which tend 
to make growth a desirable objective, some other forces work 
directly on the businessman himself. Professor Galbraith has 
written vividly of the important relationship of power to size 
in our society. 2 If a society gives its accolades to the "biggest" 
it is not surprising that members of the society will strive to 
become the biggest. As has been suggested many times, the 
high top rates of personal-income taxation tend to restrict severe- 
ly the accumulation of wealth, and thus growth of his enter- 
prise may be the only symbol of achievement available to the 
manager. 

The reasons behind the emergence of growth as a principal 
corporation objective no doubt include all of the above and 
many more. No doubt a certain amount of simply running in 
order to stand still is also involved. One might suggest that a 
significant portion of the effort in such industries as soap and 
tobacco results not in growth of those industries or of the 
companies in them but results rather in keeping any one com- 
pany from being squeezed out. Whatever the reasons for it, the 
increased emphasis on growth seems to have relegated profit 
maximization out of its primary position in the hierarchy of 
corporate goals. 3 For a very long time (certainly since Adam 
Smith) it was accepted dogma that businessmen made their de- 
cisions with an eye to maximizing profits. Businessmen do try 
to earn profits, but the idea of a reasonable profit seems to have 
displaced to some extent the concept of maximized profits. We 
are told, for example, that "one of the important tasks of Sears' 
territorial vice-presidents, in fact, is to be certain that their 



2 J. K. Galbraith, /American Capitalism: The Concept of Countervailing 
Power (rev. ed., Boston: Houghton-Mifflin Co., 1956), chap. III. 

3 One has the impression that professors and researchers in business adminis- 
tration have, in large numbers, recognized that profit maximization is no longer 
the primary objective of corporations, (cf. R. N. Anthony, "The Trouble with 
Profit Maximization," Harvard Business Review, Vol. 38, No. 6 [Nov.-Dec. 
i960]. Economists seem to have continued to cling to the profit-maximization 
asssumption to a far greater extent, though not all economists have done so (cf. 
J. K. Galbraith, op. cit., and W. J. Baumol, Business Behaviour, Value and 
Growth, [New York: Macmillan Co., 1959]). 

20 



CORPORATION OBJECTIVES AND ACCOUNTING 

local managers do not maximize profits." 4 The growth study 
referred to earlier suggests: 

Few businessmen would argue with the simple statement that 
the primary aim of a business in a free enterprise economy is to 
make a profit. But this implies not only a profit today, but also 
continued profits tomorrow. For a company is only "successful" if 
it is laying the framework for a continuously profitable future, as 
well as producing a satisfactory profit today. 5 

One reason for a diminishing emphasis on maximum profit 
is not hard to find for it is surely related to the declining in - 
fluence of the shareholder . (There may be a question of which 
is cause and which is effect here, but it does not seem significant.) 
By tradition, by usage, indeed by law, profits belong to the 
stockholders. That is to say that while profits may be retained 
for use in the business without the specific approval of the 
stockholders, the only other use to which they may be put is 
disbursement to stockholders. In many European countries man- 
agement is entitled to a tantieme or bonus specified by law as 
a certain percentage of profits, but in general bonuses must be 
paid to our manager before profit is calculated. They are an 
expense of the business. As long as the stockholder was supreme, 
there was strong argument for operating the business in a way 
which would maximize "his" profits and the amounts which 
could be disbursed to him. Once the stockholder was relegated 
to a status which is, at best, coequal with virtually everyone 
else in the community, it became rather pointless to continue 
striving to accumulate that which only he could have. 

The tendency away from maximum profit as an objective, 
then, is closely related to the acceptance of the idea of wide- 
spread corporate responsibilities and the simultaneous rejection 
of responsibility to stockholders alone. There is an abundance of 
examples of corporate activities which have only the most tenu- 
ous connection (if any connection at all) with profit maximiza- 



"Herryman Maurer, Great Enterprises (New York: Macmillan Co., 1959), 
p. 113. 

^Environmental Change and Corporate Strategy (Menlo Park, Calif.: Stan- 
ford Research Institute, 1960), p. 4. 

21 



Contemporary Corporate Accounting and the Public 

tion. The steady and increasing flow of corporate philanthropy 
generally and support of higher education in particular seem 
unlikely to maximize profits— especially when the money sup- 
ports poets and philosophers. (Nor is it related to the traditional 
"best interests of the stockholder," for there may still be Harvard 
men among the ranks of shareholders who are quite adamant 
about not wanting any of "their" money to go to Yale.) 

Many construction decisions involve aesthetic considerations 
which give an opportunity to add to the luster of corporate good 
citizenship but almost surely do not maximize profits. One may 
commend Seagrams for creating a work of art while erecting an 
office building, rather than adding to our oversupply of un- 
imaginative, uninspired glass and stainless-steel cubes. At the 
same time, one may wonder whether Seagrams will sell enough 
additional whiskey to those aesthetically pleased by the building 
to offset its cost. 

The railroads gave up millions of dollars in profits by their 
failure to attempt to liquidate money-losing passenger services in 
the late 1940's and early 1950's. Regulatory commissions, of 
course, frequently prevented liquidation, but the companies often 
did not initiate action, and among the reasons for this was the 
obligation they felt to the communities served. 6 

It will be pointed out by some that a fairly high rate of 
corporate-income taxation encourages philanthropy, expensive 
art in banking rooms, and the like since, in general, these are 
tax-deductible expenses. Uncle Sam, it is suggested, pays 50 
per cent of the cost. So he does, but it is equally true that the 
remaining 50 per cent is at the expense of the stockholders. High 
rates of income taxation may have encouraged the drift away 
from profit maximization but they do not explain it. 

The apparent displacement of profit maximization by main- 
tenance of competitive position and growth as the major ob- 
jective of corporation managers— a phenomenon with far-reach- 
ing implications in itself— is of first-rank importance in any 



6 Dwight R. Ladd, Cost Data for the Management of Railroad Fassenger 
Service (Boston: Division of Research, Harvard Business School, 1957), chap. 
III. 

22 



CORPORATION OBJECTIVES AND ACCOUNTING 

consideration of contemporary accounting. If maintenance of 
position and growth is the primary objective of corporations and 
if this is generally accepted as a proper and just goal, corporate 
performance needs to be appraised on this basis. Accounting 
should be providing those to whom the corporations are re- 
sponsible with information on which to base such appraisal. 
To an unfortunate degree, contemporary accounting provides 
the form but not the substance of this information. 

The successful maintenance of position or achievement of 
growth over a period of time is manifested by a comparison of 
resources held at the beginning and end of that period of time. 
Have a corporation's aggregate resources or stock of capital in- 
creased or diminished or stayed the same over a period of time? 
To what extent are any changes the result of either new capital 
received from or distributed to persons outside the corporation 
on the one hand, or directly from the production and distribution 
of goods and services? Answers to these questions are the most 
direct indications of whether management has, in fact, main- 
tained the corporation's position or achieved growth or caused 
decline. 

The balance sheet and the funds statement are the principal 
sources of such information. The balance sheet is a dual descrip- 
tion of the corporation's capital at any particular point in time, 
with the sources of the capital (creditors, stockholders, profitable 
operations, etc.) and the uses to which the capital is being put 
(cash, inventories, plant, etc.) the two elements of the descrip- 
tion. The funds statement is a description of the changes which 
have taken place during a period of time in these sources and 
uses of capital, indicating changes resulting from operations, 
from new resources brought into the corporation, from with- 
drawal of resources from the corporation, and from shifting of 
resources within the corporation. 

The balance sheet has always been a part of corporate 
financial reports. The funds statement is a much more recent 
addition to these reports and is not yet universally included. 
(One hopes for universal acceptance of the recommendations 

23 



Contemporary Corporate Accounting and the Public 

contained in a recent AICPA research report 7 which would give 
the funds statement a status in corporation reports in all ways 
equal to that of the balance sheet and income statement.) 

Unfortunately, the typical balance sheet (and the funds 
statement derived from it) does not give the sort of information 
it should. Because of the conventional bases for the valuation of 
resources and capital, the statements do not generally indicate 
current resource and capital values. Thus they do not make 
possible measurements of growth. The basis for resource and 
capital valuations is the subject of a subsequent chapter. For the 
moment it can be said that the single-minded attention to in- 
come measurement has resulted in the balance sheet being little 
more than a residual. LIFO inventory valuation, for example, 
may result in a more reasonable measure of current income (see 
Chapter Seven) but it results in values for inventories which 
bear virtually no relation to the actual current value of the 
goods themselves. The significant understatement of the value 
of various production and distribution facilities held under lease 
which results from current procedures for accounting for these 
leases is often excused or condoned on the grounds that the mea- 
surement of income is not distorted by these accounting proce- 
dures (see Chapter Eight). Other similar situations are discussed 
in subsequent chapters. Taken together they indicate the extent 
to which accounting seems to have ignored the shift in cor- 
porate objectives from maximizing net income to the mainte- 
nance of position and growth. It is not the intention here to 
suggest that net income is unimportant and that accounting 
should ignore it. However, statements of current resource values 
and explanations of changes in these values are most pertinent 
to appraisals of the extent to which a goal of maintaining posi- 
tion and growing has been met. Consequently, accounting should 
devote far more of its attention to these measures and should 
cease regarding them as simply residuals of the process of annual 
income determination. 



Terry Mason, "Cash Flow"" and The Funds State?ne?it (Accounting Re- 
search Study No. 2) (New York: American Institute of CPA's, 1961). 

24 



COMPARABILITY IN 
CORPORATION REPORTS 



To those who have understood the processes of accounting, 
it has always been known that two qualified accountants could 
each calculate the profit of the same business for the same period 
of time or calculate the value of any of the resources of that 
business and, in either case, could arrive at significantly different 
amounts. It must hastily be added that in doing so the account- 
ants would act with equal skill, with complete honesty, and 
would always utilize only recognized and accepted accounting 
procedures. Corporation reports can be prepared in diverse ways 
and quite typically are. 

Those who understand accounting also know that account- 
ants have gone through the past fifteen or so years of constantly 
changing monetary value assuming that, like Gertrude Stein's 
rose, a dollar is a dollar is a dollar. Accounting is possibly the 
only system of measurement which has accepted the Herculean 
task of trying to make measurements with a constantly changing 
measuring stick. 

Essentially free choice from among a too-wide range of 
measurement criteria and the use of an unpredictably variable 
measuring stick have had the predictable result: there may be 
little comparability among the reports of several corporations- 
even of those in the same industry— and, as a result, the usefulness 
of these reports in evaluating the performance of the corpora- 
tions is severely restricted. 

25 



Contemporary Corporate Accounting and the Public 

Uniformity in Accounting Procedure 

It is to the credit of the accounting profession that it has not 
attempted to obscure the permissiveness of its procedures; in- 
deed, members of the profession have publicized it quite regu- 
larly. In 1957, in a speech subsequently given wide circulation, 
Marquis Eaton, then president of the American Institute of 
Certified Public Accountants, stated "that two otherwise iden- 
tical corporations might report net income differing by millions 
of dollars simply because they followed different accounting 
methods— and that the financial statements of both companies 
might still be . . . in accordance with generally accepted 
accounting principles." 1 Reasons for this situation are not hard 
to find for there are acceptable alternative procedures for vir- 
tually every accounting problem. The most significant of these 
problems are probably inventories, depreciation of plant and 
equipment, and so-called intangibles, all of which are discussed 
in some detail in later chapters. 

This situation can be briefly illustrated by considering the 
accounting for a business' $1000 investment in a new piece of 
equipment estimated to have a useful life of twenty years. Under 
the current practice of income determination it is necessary to 
deduct the f 1000 against the gross revenue of the succeeding 
twenty years "in a systematic and rational manner." 2 This seems 
a relatively simple and straightforward matter until one turns to 
a standard work such as Depreciation by Grant and Norton 
and finds at least ten rational and systematic manners from which 
to choose. The amount of depreciation expense to be deducted 
from gross revenues in the first year of the life of this equip- 
ment could be $125, $100, $75, $50, $25, as well as an unpre- 
dictable amount related to use of the equipment. 3 All other 
things remaining the same, the company's profits could vary 



Trom an address by Marquis G. Eaton delivered before the Illinois So- 
ciety of Certified Public Accountants, June 7, 1957. 

2 American Institute of Certified Public Accountants, Accounting Termi- 
nology Bulletin Number 1 (New York, 1961), paragraph 56. 

3 E. L. Grant and P. T. Norton, Jr., Depreciation (New York: Ronald 
Press, 1949), chap. 10. 

26 



COMPARABILITY IN CORPORATION REPORTS 

by these amounts and the net book value of the particular equip- 
ment would range from $975 to $875 after one year. Where 
millions of dollars of plant and equipment are involved these 
differences would themselves be in the millions. 

This situation creates two major problems for anyone at- 
tempting to use accounting statements and reports to evaluate 
corporations' performance. The first of these problems, already 
referred to, is that it can make comparisons among even rela- 
tively similar companies quite meaningless. It is true that inter- 
company comparisons are of limited value at best, because even 
similar companies may, at any particular time, be subject to quite 
different conditions. However, comparisons can give rough in- 
dications of relative performance and suggest the extent to which 
a corporation is carrying out its avowed responsibilities. It is, 
therefore, important that these comparisons not be vitiated by 
the use of completely different accounting procedures. 

In the second place, and in terms of a single company, his- 
torical analysis of the company's statements can be seriously 
distorted by changes in accounting methods. In this connection 
it should be observed that there is an increasing and laudable 
tendency on the part of corporations who have changed ac- 
counting procedures to rework at least the significant figures 
for the preceding five or ten years and to publish the data on 
both the old and the new basis. 

Of perhaps greater significance is the fact that the extremely 
different values which result from the use of different accounting 
methods make it virtually impossible to evaluate claims (and 
counterclaims) that corporation profits are too low (or too 
high) relative to demands for increased wages, increased divi- 
dends, lower prices, or whatever happens to be the issue of the 
moment. Beyond this, of course, is the obvious possibility for the 
judicious and unannounced selection of a different accounting 
method to suggest that operating results were better (or worse) 
than would be indicated by different accounting methods. In 
general, this possibility has been severely restricted by the fact 
that the public accountant's certificate states that statements are 

27 



Contemporary Corporate Accounting and the Public 

prepared on a "consistent basis," and the practice of accountants 
to take exception in their certificate when this is not the case. 

Thus, there is some protection against deliberate abuse of the 
uncertain state of accounting procedure. There is no protection 
against the destruction of comparability which results from this 
lack of uniformity. There are two fairly obvious remedies for 
this situation: some sort of enforced uniformity of procedure, or 
a complete disclosure of accounting methods used as an integral 
part of any accounting statement. 

Since the second of these remedies seems vastly less effica- 
cious, it will be briefly discussed now before turning major at- 
tention to the much more important possibility of enforced 
uniformity. The objective of full disclosure of accounting 
methods used would presumably be to enable the user of the 
report to make it comparable with other reports by adjusting 
various results for different methods used. If disclosure of 
method is not to provide for the possibility of comparability 
there would seem to be no particular reason for the disclosure. 

The most obvious difficulty with this procedure is that unless 
it is assumed that all users of accounting reports were quite 
familiar with accounting procedure and terminology, useful dis- 
closure would probably require something approaching an ac- 
counting manual. The very detail required to make the disclosure 
of method useful to users of the statements would be so involved 
that it would be virtually useless. 

Secondly, it is doubtful that disclosure of method alone 
would be sufficient to make possible the adjustments necessary 
for comparability. In a great many instances these adjustments 
could only be made with information about method and about 
amounts involved. A trained accountant or analyst would know 
in a general way the result of using any one of the several 
depreciation methods, for example; but without data on cost, 
age, and expected life of the plant (and all other plant and 
equipment) he could not convert the results to those which 
would be obtained with another method. In other words, to 
make comparability effective, reports would have to include not 
only disclosure of procedures used but, in addition, the results 

28 



COMPARABILITY IN CORPORATION REPORTS 

which would be obtained from different procedures. All in all, 
disclosure of accounting methods used does not seem a very 
useful way of overcoming the problem created by lack of uni- 
formity. 

The arguments against enforced uniformity have been stated 
on many occasions. The nearest thing to an official argument is 
found in the introduction to the accounting research bulletins of 
the American Institute of Certified Public Accountants: 

Uniformity has usually connoted similar treatment of the same 
item occurring in many cases, in which sense it runs the risk of 
concealing important differences among cases. Another sense of 
the word would require that different authorities working inde- 
pendently on the same case should reach the same conclusions. Al- 
though uniformity is a worthwhile goal, it should not be pursued 
to the exclusion of other benefits. Changes of emphasis and ob- 
jective as well as changes in conditions under which business operates 
have led, and doubtless will continue to lead, to the adoption of 
new accounting procedures. Consequently diversity of practice 
may continue as new practices are adopted before old ones are 
completely discarded. 4 

Mr. Marquis Eaton, in the address quoted from before, sug- 
gested: 

It would be a great misfortune for American business, and the 
whole economy, if uniform accounting rules were to be prescribed 
by governmental fiat. It would probably mean the end of progress. 
The Interstate Commerce Commission did exactly this in 1914 for 
the regulated railroads. At the time the I.C.C. accounting classifi- 
cation was hailed as reflecting the best accounting thought of the 
day. It was cited as a model in accounting textbooks. By 1957 it 
was completely out of date— far behind the financial reporting 
standards of industrial corporations. 

The essential arguments against uniformity thus seem to be 
the fear that it would conceal important differences and, most 
important, that it would stifle the development of accounting. 

As far as concealing differences is concerned, this would only 
happen with a degree of uniformity which no one of whom the 



"American Institute of Certified Public Accountants, Accounting Research 
and Terminology Bulletins (final ed., New York, 1961), pp. 7-8. 

29 



Contemporary Corporate Accounting and the Public 

writer is aware has ever contemplated. For example, uniformity 
does not imply that industries such as tobacco and distilled liquor 
which have very special inventory problems would have to 
account for these in exactly the same way as industries which do 
not have these problems. The automobile manufacturers have to 
contend with immense tooling costs; steel makers have to account 
for the periodic rebuilding of furnaces; oil companies have under- 
ground reserves. Uniformity would simply mean these particular 
cases would be accounted for in a uniform fashion by those who 
have the particular problem. It would in no way involve other 
corporations in these problems. On the other hand, uniformity 
would presumably mean, for example, that all ordinary industrial 
plant and equipment would be accounted for in the same fashion. 
There seems no reason to believe that this would conceal truly 
important differences. 

Mr. Eaton is not the only commentator to have cited the 
Uniform System of Accounts for Class 1 Railroads of the Inter- 
state Commerce Commission as an illustration of the evils of 
enforced uniformity in accounting. I have, in the past, been a 
severe critic of this particular system, 5 but its particular weak- 
nesses are not necessarily relevant to the broader situation being 
discussed here. The reasons for stagnation in the railroad in- 
dustry are many and varied. Undoubtedly the accounting sys- 
tem has been one among these, but just as surely some of the 
other factors have been reasons for stagnation in the thinking of 
railroad accountants both in the companies and in the ICC. 

Furthermore, it is important to recognize that the ICC sys- 
tem is, in the first instance, a system of bookkeeping rather than 
a system of accounting. That system sets forth in extreme detail 
rules for recording literally thousands of transactions. There is 
no doubt that this sort of uniformity would stifle even the most 
vivid imagination, but such a system is a far cry from enforcing 
a degree of uniformity in reporting on such things as inventory, 
depreciation, and intangibles. Experience with the railroad ac- 



c In Cost Data for the Management of Railroad Passenger Service (Boston: 
Division of Research, Harvard Business School, 1957), chap. IV. 

30 



COMPARABILITY IN CORPORATION REPORTS 

counting system is not really relevant to the question of uni- 
formity in reporting. 

The Committee on Accounting Research suggests that 
changes in conditions have led and will continue to lead to 
changes in accounting methods. There seems no good reason to 
believe that those who might have responsibility for enforcing 
uniformity would be any less aware of these changes than would 
those actually doing the reporting. Furthermore, in addition to 
the thousands of practicing accountants there are hundreds of ac- 
counting professors in the nation's colleges and universities. If 
even a tiny portion of these latter are doing their jobs as they 
should there will be no failure of recognition of changed condi- 
tions, no lack of suggestions for new and better methods. 

The present system has been described as follows: 

New developments in accounting principles and related prac- 
tices, in general, go through transitional periods as a result of an 
evolutionary process. This process tends to follow a course that 
might be divided into five transitional phases. . . . 

These transitional phases have occurred and are occurring, usual- 
ly over a period of many years. . . . While it is recognized that an 
evolutionary type of transition usually cannot be accomplished 
quickly and that a period of experimentation may be necessary, 
some of the transitional hurdles are simply road blocks that favor 
the status quo. The public accountant's responsibility for meeting 
today's accelerated pace of business development may not permit 
leisurely transition periods of ten to fifteen years or longer. 6 

The present system of development of accounting proce- 
dures is rather like the New England attic— nothing is ever 
thrown out. Surely this results in part from inertia— from an 
unwillingness to change procedures which have worked in the 
past— a characteristic no more prevalent among accountants 
than among any other group. It also results, no doubt, from an 
unwillingness to undertake an often difficult explanation of ap- 
parent changes in operating results or in values which result 
from changes in accounting procedures. Above all, it results 



"Arthur Anderson & Co., Accounting and Reporting Problems of the Ac- 
counting Profession (Chicago, 1960), pp. 3-4. 

31 



Contemporary Corporate Accounting and the Public 

from a lack of discipline among that very widespread group who 
develops accounting ideas and puts them to use, a matter dis- 
cussed more fully in Chapter Twelve. 

One reason for reluctance to change accounting methods 
which is rarely articulated but is nevertheless a strong deterrent 
is the relatively large change in amounts which changes in 
method may involve. For example, the Imperial Tobacco Com- 
pany of Canada, the largest tobacco manufacturer in Canada, 
restated its land, buildings, and equipment from historical cost 
to replacement cost in 1961. This restatement involved an in- 
crease of over $25 million— from $58 million to $83 million. Ob- 
viously such a change in amounts from one year to the next has 
a tremendous impact. Even with a great deal of careful explana- 
tion of objectives, methods, and adjustments (and Imperial 
Tobacco gave a generally excellent explanation) the likelihood 
of uncertainty in a reader's mind cannot be denied. 

On the other hand, it must be remembered that these large 
changes will occur only once. Subsequent changes will reflect 
only the normal change in values as stated on the new basis. In 
the case of Imperial Tobacco, the increase in replacement value 
of land, plant, and equipment between 1960 and 1961 was only 
about $600,000, part of which was accounted for by net increase 
in resources held. In the case of price-level adjustments (to be 
discussed below), it would require an essential doubling of the 
monetary amount of an asset held since 1945 to account for the 
roughly 50 per cent decline in the purchasing power of money 
since that time. After this initial adjustment was made, however, 
subsequent adjustments would need only account for the current 
annual rate of decline in purchasing power, say 2 per cent to 
3 per cent. 

The initial adjustment of monetary sums often required by a 
change in accounting methods is a matter which requires a care- 
ful and full explanation by those who prepare the statements. 
Readers of statements must, in turn, accept the obligation to 
make the effort to understand the changes and particularly to 
understand that the magnitude of the difference is not indicative 
of a similar change in the immediate, short-run status of the 

32 



COMPARABILITY IN CORPORATION REPORTS 

corporation. That these requirements for explanation and under- 
standing can be met must be assumed and the magnitude of the 
initial difference resulting from changes in accounting method 
not allowed to prevent needed improvements. 

Changing Price Levels 

The fact of changing price levels is too well known to require 
elaboration. During the years since World War II, the pur- 
chasing power of the dollar has declined by about 50 per cent, 
and since the dollar is the basis of virtually all accounting mea- 
surements the implications are obvious. For example, assume that 
a company acquired an asset in year x for $100,000. A second 
company acquiring an exact duplicate of the asset one year later, 
because of a decline in the purchasing power of money, would 
have paid $120,000 for it. These sums are included among the 
accounting listings of each company's assets, and all else being 
equal a reader of the statements would conclude that the second 
company was worth more than the first. By any reasonable 
definition of "worth" this is manifestly not so. 

The other side of this coin is seen in any consideration of the 
sources of the funds used to acquire the company's assets. Gen- 
erally speaking, in our past two decades of inflation the debtor 
has been in a favorable postion because his obligation to repay is 
based on the value of money at the time he incurred the debt. 
As the value of money decreases these fixed payments become 
less and less of a burden to the debtor. Thus, the postion of a 
company with a debt of $100,000 acquired in 1950 may be quite 
different from the position of a company with the same amount 
of debt taken on in 1955. 

The effects of inflation upon profit determination are dis- 
cussed in some detail in a subsequent chapter. For the moment, 
it is sufficient to point out that for the most part a company's 
revenues will be in current dollars while expenses currently 
being deducted from these revenues may well represent past 
expenditures of quite different dollars. Thus, the operating re- 
sults of the two otherwise identical companies may be quite dif- 

33 



Contemporary Corporate Accounting and the Public 

ferent depending on when the dollars currently being charged 
off were actually spent. 

The continued ignoring of changing dollar values means that 
the dollar amounts of a company's assets may be quite mean- 
ingless in terms of current dollar values and in terms of com- 
parisons with other companies. The same is true of a company's 
debt. The conventional calculation of profit may result in quite 
distorted figures when no recognition is given to changing dollar 
values. 

This situation has probably received more discussion than 
any other aspect of accounting in the past fifteen or so years. At 
the same time perhaps less has been done about it than about 
any of the other problems of accounting. The big surge of 
inflation in 1947 and 1948 led to a vast amount of discussion and 
some limited action. Some corporations such as Chrysler and 
U. S. Steel made adjustments of depreciation charges (which, 
of course, only get at one aspect of the problem) in their annual 
reports. The American Institute of Certified Public Accountants 7 
through its Committee on Accounting Procedures, disapproved 
of these limited attempts to deal with the situation and, by 
implication, with other, more vigorous action. 

While there are differences of opinion, the prevailing sentiment 
in these groups [businessmen, bankers, economists, labor leaders and 
others] is against any basic change in accounting procedures. The 
committee believes that such a change would confuse readers of 
financial statements and nullify many of the gains that have been 
made toward clearer presentation of corporate finances. 8 

In 1951 the American Accounting Association's Committee 
on Concepts and Standards issued a statement encouraging the 
use of supplementary statements in which monetary amounts 
were adjusted for changes in monetary values. This group felt 
that experimentation was needed before the best way of dealing 
with the situation could be determined. 9 



7 American Institute of Certified Public Accountants, Accounting Research 
and Terminology Bulletin (final ed., New York, 1961), chap. 9. 

Hbid., p. 69. 

9 American Accounting Association, Price Level Changes and Financial 
Statements, Supplementary Statement No. 2 (1951). 

34 



COMPARABILITY IN CORPORATION REPORTS 

More or less as a result of this call for experimentation, the 
association with grants from the Merrill Foundation sponsored a 
study of four companies, directed by Professor Ralph C. Jones 
of Yale. This study, published in 1955, indicated that the dis- 
tortion in accounting values, created by a failure to adjust for 
changing monetary values, was substantial indeed. 10 While this 
study left little room for doubt that inflation (and the deflation 
of the 1930's, too) made accounting statements with unadjusted 
dollar amounts virtually meaningless, it did not generate any 
significant change in accounting practice generally. Indeed, in 
June, 1959, Mr. Carmen Blough, then director of research of the 
AICPA, stated: 

However, though I acknowledge the soundness of complete 
adjustment for price-level changes as a matter of principle or theory 
I do not feel that it is practical at this time. How far must inflation 
go before it would be practical? I do not know but it would have 
to be far enough for its significance to be understood by many 
more than understand it today. 11 

In 1961, Professor Moonitz, successor to Mr. Blough as 
research director of the AICPA, was urging that the 1951 pro- 
posals of the American Accounting Association for experimenta- 
tion with supplementary statements adjusted for price-level 
changes be implemented. 12 As those of the gods, the mills of 
accounting grind slowly. 

The stated arguments against the adjustment of accounting 
data seem to center on three points: (1) there has not yet been 
enough inflation to make the problem critical; (2) neither a 
general index, such as a Consumer Price Index, nor a special 
index is very exact; (3) statements given in adjusted dollars are 
difficult to understand. Among the unstated arguments the 
inertia and reluctance to change referred to above no doubt loom 
large. 



10 Ralph C. Jones, Price Level Changes and Financial Statements, Case Studies 
of Four Companies (American Accounting Association, 1955). 

"From an address before the National Association of Accountants, New 
York, June, 1959. 

"Maurice Moonitz, The Basic Postulates of Accounting (New York: 
American Institute of Certified Public Accountants, 1961), pp. 44-46. 

35 



Contemporary Corporate Accounting and the Public 

The first of these arguments is entirely subjective, of course. 
The evidence of the Jones study and a more recent study by 
E. S. Hendricksen 13 indicate there has been enough inflation to 
distort seriously accounting results. When adjusted statements, 
as in the case of Armstrong Cork Company, show that average 
return on equity was 4.5 per cent compared with 8.8 per cent 
shown by unadjusted statements, 14 one might reasonably con- 
clude there has been more than enough inflation to warrant 
taking positive action. 

The statement that the Consumer Price Index or some other 
index is not exact is, of course, quite true. It is also a completely 
irrelevant argument because it is based on the assumption that 
what the index would replace is itself exact. This assumption 
is quite false for it is certain that unadjusted dollar amounts in a 
period of fluctuating monetary values are wrong. The use of an 
index to adjust dollar values, then, can be said to substitute some 
probability of being approximately correct for the virtual cer- 
tainty of being absolutely wrong. 

In this connection, it is of interest to note that several 
European governments publish official indexes for use by com- 
panies in adjusting monetary values in connection with the 
calculation of taxable income. (These indexes are developed 
specifically for various classes of machinery and equipment. 
Some writers have argued that such indexes only partly measure 
monetary inflation and are partly measuring improvements or 
changes in the particular equipment, that is, measuring replace- 
ment value. A general index, such as the Consumer Price Index, 
is often recommended on the grounds that it gives the best 
measure of general inflation as such.) 

The fact that adjusted data are more difficult to understand 
is undeniable, but this is not a good reason for failing to correct 
a manifestly bad situation. After all, many people still do not 
understand the parable of the talents but this did not prevent 
Jesus from telling it to us. In general, it must be assumed that 



13 E. S. Hendricksen, Price-Level Adjustments of Financial Statements (Pull- 
man, Wash.: Washington State University Press, 1961). 
"Ralph C. Jones, op. cit., p. 67. 

36 



COMPARABILITY IN CORPORATION REPORTS 

most people involved in evaluating corporations' performances 
are reasonably intelligent and reasonably well educated. Invest- 
ment dealers, union officials, Representatives and Senators, jour- 
nalists, university professors, government officials will either be 
well able to contemplate data adjusted for price-level changes 
or will have ready access to staff members who are. And once 
again in this connection, one must ask whether it is not better 
to educate people to manage difficult concepts than to mislead 
them with the false assurance of simple concepts. 

Summary 

Contemporary accounting practice offers the accountant a 
fairly wide and essentially free choice of rules and procedures 
for dealing with most accounting problems. Accounting bases 
most of its measurement on the monetary unit, and in general 
practicing accountants have not taken steps to eliminate the 
effects of inflation on the monetary unit. Thus, there is relatively 
little comparability among the periodic reports of single enter- 
prises, nor is it possible to make reasonable comparisons among 
the reports of several corporations. 

It must be recognized that neither last year's performance of 
Company A nor this year's performance of Company B are 
necessarily valid criteria for evaluating this year's performance 
of Company A. On the other hand, such comparisons are an im- 
portant part of the evaluatory process. The usefulness of the 
information typically available about corporations is seriously 
limited by the variety of accounting procedures and by the 
failure to eliminate effects of price-level changes. 



37 



(chapter ^srt 



T 



we 



THE PROCEDURAL BASES 
OF ACCOUNTING 



i 

Accounting for the large modern corporation involves the 
accountant in a dual role. One role, which has dominated the 
preceding discussions, is as a means of communication between 
corporation managements and properly interested outsiders. In 
its second role accounting is a system of measurement, measuring 
the results of the myriad of financial transactions which are in 
turn the reflection of a wide range of business decisions and 
actions. That accounting's role is dual should not be lost sight of, 
for it is simultaneously measurer and communicator. What it 
communicates is largely determined by how it measures, and 
how it measures must be determined by what it intends to 
communicate. 

II 

In terms of both measurement and communication it is essen- 
tial to recognize that there are necessary and desirable limits 
upon the phenomena with which accounting can deal. Account- 
ants have generally maintained that they are concerned only 
with financial matters, with those phenomena susceptible to 
measurement in financial terms. Thus accounting would not at- 
tempt to measure and report upon such things as employee 
satisfaction, the wisdom of a pricing policy, the taste of adver- 
tising, etc. Behavioral scientists with long training and experience 
have difficulty measuring employee satisfaction. Economists 

38 



THE PROCEDURAL BASES OF ACCOUNTING 

debate pricing policy at length. Advertising is quarreled over 
and "researched" constantly by experts and laymen with little 
more than confirmation of one's prejudices as a result. All these 
matters are sufficiently remote from the background and training 
of most accountants to make these self-imposed prohibitions 
perfectly sound and appropriate. 

It is appropriate that accounting has limited itself to financial 
matters, but it is unfortunate that the limits around what shall be 
considered as financial matters have, in practice, been very nar- 
rowly defined. Cash on hand is clearly a financial resource and 
so are inventories of materials or goods for sale. There is no 
question that plant and equipment are resources. But what of a 
trade-mark such as "Coca-Cola" or "Ivory Soap"? And what of 
the partly formed idea for an ultimately successful product in 
the mind of a chemist or engineer in the research laboratory? Or 
what of the imagination, intelligence, and skill of the president 
who directs the company? Most would agree that all these are 
very significant resources. Indeed, in this day when many com- 
panies can make a great variety of things with equal speed and 
efficiency, it seems that those factors which lead to the develop- 
ment of new things to make and to the speedy and efficient 
distribution of these things are at least equal in importance to 
raw materials and production machinery. Accounting, however, 
has continued to give most of its attention to the resources used 
in making things— usually referred to as tangible assets— and, of 
course, to monetary assets such as cash, accounts receivable, and 
securities. Accountants have not said that these other, intangible 
assets are nonfinancial and therefore beyond the limits of ac- 
counting, but by failing to give much serious attention to the 
difficult problem of valuing them the result is much the same: 
many intangible resources are not valued and not recognized. 
Some specific problems of accounting for intangibles are dis- 
cussed in Chapter Eleven. For the moment it is enough to 
recognize that in practice accounting has unfortunately limited 
itself to so-called tangible assets, even though we recognize the 
widsom of the broader limitation to financial matters. 

It is also important to recognize the essentially subjective 

39 



Contemporary Corporate Accounting and the Public 

nature of the conventions and rules underlying the theory and 
practice of accounting. Most measurement systems with which 
we are familiar are based on natural laws or physical relation- 
ships derived from the phenomena being measured. There are 
no such laws or relationships in business transactions, nor are 
the phenomena themselves necessarily manifest. Capital and in- 
come, for example, are matters of definition and thus are 
debatable and debated. Accountants are therefore forced simul- 
taneously to define the phenomena they are measuring and to 
establish rules or accepted procedures or conventions for making 
the measurements. (Traditionally these have been called the prin- 
ciples and postulates of accounting and there has been quite a bit 
of semantic argument about whether the measurements are based 
on postulates or principles. A different term "convention" will 
be used here because it seems most appropriate. The Merriam- 
Webster defines conventions as rules and practices which have 
as their sanction custom and usage and it is on exactly such that 
accounting is based.) 

These conventions are essentially the practical and con- 
sidered responses of the persons who first used and articulated 
them to the nature of the job they had to do and to the circum- 
stances surrounding the job including, no doubt, their own 
attitudes. For example, consider the convention of conservatism 
which is generally taken to mean that when there is uncertainty 
and choice, resources should be undervalued rather than over- 
valued, income should be understated rather than overstated. 
Surely such a convention reflects a state of mind rather than a 
necessarily natural or obvious basis for measurement. That con- 
servatism has general acceptance as a factor in measurement re- 
flects the fact that the men who proposed it in the first place 
were conservative men, and its continued acceptance is surely 
because the men who have followed them in • accounting are 
conservative men. Were the radicals in the population attracted 
to accounting, the convention would surely be different. 

There has been some evolution and much discussion of these 
conventions over the years, but basically they have remained 

40 



THE PROCEDURAL BASES OF ACCOUNTING 

unchanged for some time in spite of great changes in the nature 
of the accountant's job. This continued acceptance of these 
conventions should reflect the considered opinions of those who 
have continued to accept and use them that they are still valid 
responses to the nature of the job to be done and to the circum- 
stances which surround it. Perhaps it does. One may, however, 
at least suggest the possibility that the basically subjective origin 
of these conventions has been lost sight of and that they have 
become dogma not because of any inherent validity but simply 
because of general and continued usage. In the following pages, 
those accounting conventions which seem to have continuing 
validity are briefly described. 



Consistency 

Consistency in accounting means that accounting policies and 
procedures should be the same over a succession of accounting 
periods. To the extent that the idea of consistency prevents the 
making of capricious and short-run changes in accounting and 
reporting, it may be useful. Beyond this, however, it frequently 
serves as a cloak behind which those who are reluctant to change 
can hide. Progress in accounting and consistency in accounting 
are not always compatible. 

Materiality 

The convention of materiality simply means that all material 
or significant transactions, values, and contingencies should be 
disclosed in accounting reports. The converse, of course, is that 
such reports should not be cluttered with immaterial or insignif- 
icant data. How influential this convention has been to date is 
indicated by the fact that millions of dollars of intangible but 
important resources go unaccounted for in financial reports that 
carry the "value" of unexpired fire-insurance premiums to the 
exact penny. Because of the importance of accounting's role in 
communicating business facts to outsiders avoidance of the sin 
of omission is most necessary. Because communication cannot be 

41 



Contemporary Corporate Accounting and the Public 

very effective unless it is understandable, the sin of commission 
is as much to be avoided. 

Money 

The role of money in accounting is, as the role of money 
elsewhere is generally thought to be, a matter of considerable vir- 
tue and a source of considerable evil. The virtue of money is that 
it provides accountants with an absolutely essential lowest com- 
mon denominator. It is only through description in equivalent 
monetary terms that the "shoes and ships and sealing wax/cab- 
bages and [presidents]" or any other of an infinite number of 
combinations of things which are the stuff of a modern corpora- 
tion can be compared and analyzed. Since costs are hours of 
labor, barrels of nails, martinis at lunch, and a tremendous variety 
of other elements, income can be contemplated only after all the 
diverse elements of revenue and cost have been reduced to 
common monetary terms. Without the ability to express a great 
range of business facts on a common monetary basis, accounting 
would not be possible. 

The evils brought on by the use of money are two. In the 
first place money is generally quite unstable. Much of the con- 
fusion which surrounds the appraisal of corporate performance 
is occasioned by the instability of money over time. We have 
lived for a very long time with generally rising price levels and 
it is not certain that this will significantly change in the future. 
Thus it must be recognized that the use of monetary equivalents 
in accounting is grossly misleading unless specific provision is 
made for its instability. (See preceding chapter.) 

Money values, because they are numbers, can be readily 
manipulated with a high degree of elegance and precision, a fact 
which does not change but often obscures the essential sub- 
jectivity of much of accounting. Depending on the definition of 
cost used, a particular resource may be given values the greatest 
of which might be 100 per cent or more of the lowest. Carrying 
such values to the nearest penny simply because it is arithmetic- 
ally possible does nothing more than create a most unsound 
illusion of objectivity. In our era of great change, and as a result 

42 



THE PROCEDURAL BASES OF ACCOUNTING 

of the vastly increased scope of corporate responsibilties, the 
monetary concept must not be permitted to obscure, as it often 
does, the uncertainty and subjectivity surrounding much of 
accounting. 

Money is a convenient way of expressing financial facts and 
the use of money as the basic device is most appropriate. How- 
ever, it must be recognized that failure to adjust changes in the 
value of money makes the monetary convention utterly mis- 
leading. It further needs to be recognized that in spite of the fact 
that money values can be added and subtracted, multiplied and 
divided, they represent in a great many cases essentially subjec- 
tive and uncertain conclusions. 

Permanence 

Strictly speaking, the life of a corporation is, at any par- 
ticular point in time, of uncertain duration. Corporate charters 
are granted for periods of, for example, 99 years, 999 years, or 
simply indefinite periods, but the hopes and expectations of 
founders do not influence the sometimes harsh realities of the 
market place. Thus, a corporation may cease to exist at once or 
shortly thereafter or it may continue on indefinitely, and ac- 
counting for its current status under either of these conditions 
will be significantly different. (Resources which have great value 
when used by an operating business in the production of goods 
and services often have little or no value when put on the market 
directly because they cannot be used for other purposes.) Con- 
sequently, it has been necessary to make some convenient as- 
sumption about this matter of the life of the corporation being 
accounted for. From this need has come the going-concern or 
permanence convention which simply states the assumption that 
a corporation will continue to operate for an indefinitely long 
period in the future. The assumption would not be made in the 
face of specific knowledge of imminent liquidation, of course. 
In terms of the corporations which are the concern of this book, 
such an assumption is completely reasonable. The average life 
span of all American corporations is fairly short, but the odds 

43 



Contemporary Corporate Accounting and the Public 

that General Electric, Traveler's Insurance, U. S. Steel and the 
like will continue to exist indefinitely are overwhelming. 

Unfortunately, this convention of permanence can be in- 
terpreted in the two essentially opposite ways illustrated in the 
following statement. 

The importance of the permanence assumption can be indicated 
bv contrasting it with a possible alternative; namely, that the busi- 
ness is about to be liquidated or sold. Under the latter assumption 
accounting would attempt to measure at all times what the business 
is currentlv worth to a buyer, but under the going-concern assump- 
tion there is no need to do this, and it is in fact not done. 1 

There is a subtle but nonetheless important distinction be- 
tween the liquidation of a business and the sale of a business. 
Treating these together is a result of accounting's traditional 
exclusive emphasis on the ownership interest for from the point 
of view of the owner there is no significant difference between 
them, assuming the amount of cash he receives is the same. How- 
ever, from the point of view of all the other groups who have 
an interest in the corporation there are significant differences. 
For management and workers it is the striking difference be- 
tween continued employment and being out of work. For cus- 
tomers it is the difference between being able to continue with 
a source of supply and having to look for a new one. For the 
public in general it may be a question of the continuation or not 
of an important economic institution. Accounting which is to 
serve interests other than those of the stockholder must dis- 
tinguish between the liquidation of a business and the sale of a 
going-concern. 

It has already been implied that both the responsibilities and 
objectives of the modern large corporation are such that ap- 
praisal of their status and progress must be based on current 
values. This point will be made explicit in Chapter Six. The 
acceptance of the convention of permanence to preclude ac- 
counting in terms of liquidation is appropriate and useful. It 



'R. N. Anthony, Management Accounting (rev. ed.; Homewood, 
Richard D. Irwin, Inc., I960), p. 30. 

44 



THE PROCEDURAL BASES OF ACCOUNTING 

should not be used to support unwarranted and misleading em- 
phasis on the past, an emphasis which destroys much of the use- 
fulness of accounting as a basis for such appraisals. 

Income Taxation 

Even though it is only marginally related to the matter of 
accounting conventions, this seems a useful place to discuss in 
general terms the relationship between accounting and income 
taxation. There is no doubt that the taxation of income has had a 
great deal of influence upon accounting, especially since the 
mid-1930's when the rates of taxation first became of significant 
size. Given that a tax is to be levied on income, accounting for 
that income becomes critical for the very obvious reason that the 
amount of tax to be paid is a direct function of the amount of 
income. The use of an accounting procedure which will lower 
net income means, quite literally, money in the bank. There is 
no doubt that the adoption of the income tax greatly increased 
the opportunities of employment for accountants and gave 
powerful stimulus to the accountant's emphasis on income de- 
termination. 

In the beginning it was generally intended that the income 
tax would be based on corporate income as conventionally de- 
fined. However, there are a number of considerations involved 
in the levying of a tax which have no relevance to any accepted 
definitions of corporate income, and consequently the definition 
of taxable income has, over the years, moved farther and farther 
away from corporate income. 

Income taxation is increasingly used as a tool in implementing 
the economic and social policies of the government. For example, 
the taxable income of an oil-producing company which includes 
an essentially political deduction for depletion would satisfy no 
accounting definition of income. Income-tax regulations must 
also be concerned with equity, which is not of concern in ac- 
counting. The exclusion of dividends received by a corporation 
from that corporation's taxable income may represent equitable 
treatment of that corporation's stockholders, but it is at odds 
with any accepted basis for income determination. Nor are these 

45 



Contemporary Corporate Accounting and the Public 

broad social functions of tax policy likely to change. In 1962, 
the estimated useful lives of fixed assets generally accepted 
by the Treasury Department as the basis for computing de- 
preciation deductions for tax purposes were generally shortened. 
This is an avowed device to stimulate new investment in plant 
and equipment and thereby to stimulate the nation's economy. 
This does not mean that the basis for computing depreciation for 
corporate accounting purposes should be changed in the same 
way. The government is really not concerned with taxing in- 
come as such. It is interested in collecting needed revenues with- 
out doing unnecessary damage to the economy and it can and 
does manipulate the basis for taxation with this objective in view, 
quite without concern over whether the resulting base is, in 
fact, income as usually defined. 

Many changes are needed to make accounting more nearly 
appropriate to its role as the source of data upon which to base 
appraisals of the way the modern corporation is meeting its 
manifold responsibilities. These changes will inevitably magnify 
the differences between taxable income and corporate income 
beyond what they are at present. Consequently, it is not only 
desirable but necessary to recognize that income tax concerns 
income in name only and to end its influence on accounting con- 
cepts and procedures. 

Past and Future 

It is less convention than necessity which forces accounting 
to be primarily historical. The line between reporting facts and 
fortune telling is not always easy to draw, yet it must be recog- 
nized. On the other hand, one must also recognize the relative 
relevance of the past and the future in the process of apprais- 
ing corporate performance. Basically, data relating to the past 
can serve as a basis for rewards and punishments. They can 
also, on occasion, serve as rough guides to the future. However, 
the nature of many corporations is changing so rapidly in re- 
sponse to changes in technology and in the generally held view 
of their role and responsibility that past data quickly lose their 
significance. 

46 



THE PROCEDURAL BASES OF ACCOUNTING 

A real evaluation of corporate status and progress can be 
made only on the basis of the expected results of contemplated 
future actions. By and large, businessmen make their own de- 
cisions on the basis of such information, and the current capital 
commitments, future income, and future funds flow are key 
pieces of information in these decisions. Ideally, those concerned 
with appraising the effectiveness of such decisions should have 
the same information. 

There are obvious implications— competitive and otherwise— 
in including income budgets and funds-flow projections in cor- 
poration reports. In the first place, a considerable amount of un- 
certainty is generally inherent in such budgets or projections 
and it is probably unrealistic to expect that many who would 
use these data could or perhaps would make adequate provision 
for this uncertainty. The fact that actual performance varies 
from projected performance may result from poor management, 
but it may also be an indication of a poor, or simply unfortunate, 
forecast. Interpretation of results requires a degree of sophisti- 
cation and discretion which might not always be available. 
Furthermore, the "giving away of plans" which would be in- 
volved in making such forecasts and projections available would 
certainly have the effect of limiting whatever competition is 
left in our system, although if the practice were universally 
followed no particular corporation would be put at a disad- 
vantage. 

For these reasons alone, to suggest that budgets or forecasts 
of income and funds flow be included in corporation reports 
is certainly premature and probably impractical. On the other 
hand, it needs to be recognized that real control over the use 
of resources can only come before the resources are committed, 
and the decision to commit them to a particular use must be 
based on an evaluation of expected results. Certainly the steady 
growth of corporate influence and responsibilities demands that 
accountants begin to develop procedures by which income 
budgets and funds-flow projections can be communicated to 
those to whom the corporations are responsible— procedures 

47 



Contemporary Corporate Accounting and the Public 

which will make allowance for uncertainty and provide for the 
protection of desired competition. 

One may accept the present practical barriers to communica- 
tion to outsiders of estimates of future progress without obviat- 
ing the need of those outsiders for information oriented toward 
the future. A readily available step in the direction of meeting 
this need is to make sure that the conventional summary state- 
ments—balance sheet, income statement, funds-flow statement- 
focus on the present rather than on the largely irrelevant past. 
One step towards this objective is the adjustment of monetary 
values discussed in another connection in Chapter Four. This 
would, of course, have the effect of eliminating monetary values 
left over from an irrelevant and irredeemable past from account- 
ing statements. They would then at least be related to the 
present, which is the beginning of the future. Another principal 
step involves reconsidering some of the basic definitions under- 
lying the determination of value and the measurement of income. 
This matter is discussed in Chapter Six. Here again, the objective 
should be to have the accounting statements as current as pos- 
sible. As will be suggested, this will require some fairly major 
changes in currently popular conventions and procedures, but 
if one accepts that there have already been major changes in 
the broad social and economic role of the organizations being 
accounted for, the requirement for change in accounting is 
not something to choke upon. 



IV 

Accounting is limited to informing interested outsiders about 
only a part of the total spectrum of business affairs. Also, some 
uncertainty is inherent in accounting's bases for measurement. 
Useful accounting must be concerned with the future, yet 
accounting must avoid idle speculation and limit itself to reason- 
ably supportable statements. Unfortunately, the precise extent 
of these limitations and uncertainties is not clear, and thus there 
is always room for disagreement and continued discussion. It 
seems safe to say that no one will ever produce a definitive 

48 



THE PROCEDURAL BASES OF ACCOUNTING 

solution to the twin problems of what and how accounting 
should measure and communicate. On the other hand, it seems 
clear that the only worthwhile approach to these problems starts 
from accounting's role as a link between the corporation and 
those to whom it is responsible. Conventions, procedures, and 
rules for communication and measurement will make sense only 
if they are derived from the needs of those at each end of the 
chain of responsibility. Broadly speaking, these needs, as sug- 
gested earlier, are met by putting into the hands of interested 
outsiders— stockholders, employees, customers, suppliers, and the 
public— information which will help them to make a significant 
evaluation of the current status and probable future progress 
of the corporation and, in turn, help to establish the legitimacy 
of management. 



49 



VALUE AND CAPITAL 

i 

The single most important task of accounting is determin- 
ing the value of the various resources or of the capital of the 
corporation. (These two terms— resources and capital— are at 
one point completely synonymous. A corporation's capital is 
the aggregate of all its resources. The aggregate of the resources 
of the corporation is its capital.) These values are the founda- 
tion of all that accounting does. Capital, both in terms of indi- 
vidual resources and in the aggregate, is the essence of the 
balance sheet. Similarly, it is the essence of the funds statement 
because that description of changes in the sources and uses of 
capital must obviously start with valuation of the capital. Income 
arises as a result of the conversion of resources into goods and 
services and the distribution of goods and services. The amount 
of net income depends upon the values given to the resources 
disposed of and to the resources received in exchange. While 
problems of accounting measurement are often discussed in 
other terms, in virtually all cases they revolve around the ques- 
tion of value. In this chapter, several different definitions of 
value or of capital which have some currency in accounting 
practice or literature are considered. 

II 

The only true measure of the value of a resource is the goods 
or services or other satisfactions which will result from its pos- 
session or use in the future. In terms of the resources held by 

50 



VALUE AND CAPITAL 

a corporation, their value is their present worth, which may be 
defined as the present value of the net receipts to be received 
in the future from the use of the resources, discounted at a rate 
appropriate to the risk involved in this use. Thus, by definition, 
the capital of a corporation would be equal to the aggregate of 
the present worth of all its resources. Periodic income would be 
measured by comparing the amount of capital held at the be- 
ginning of the period with the amount of capital held at the 
end of the period. The change in present worth (after allowing 
for new investment from outside the corporation and for dis- 
tribution of value to investors) would be net income (or loss). 
It is also important that net income thus defined would, before 
any distributions, be exactly equal to growth achieved through 
operations or through holding resources. 

In terms of an appraisal of corporate status, present worth 
is a most appropriate basis for valuation. If the function of a 
corporation is to utilize most effectively the resources it controls, 
present worth has the merit of being the only basis for compar- 
ing all of the opportunities for using the resources. Present 
worth is completely forward looking, and the future is the only 
really relevant consideration in terms of control over the use 
of resources. An increase in present worth is, as suggested above, 
a precise measure of growth, a matter of considerable signifi- 
cance if the objective of corporation managers is to achieve 
growth. In terms of the responsibilities and apparent objectives 
of the large modern corporation, present worth provides a most 
suitable definition of value and capital. 

Unfortunately, however, a great deal of uncertainty is in- 
volved in the projection of future net receipts. It must also be 
recognized that there is a great deal of subjectivity involved in 
establishing the amount of risk related to a particular course of 
action. The uncertainty and the subjectivity can be, and fre- 
quently are, managed in valuations made by businessmen making 
investment decisions within the firm. This is possible because 
the men involved are few in number and in general are, or should 
be, intimately familiar with the risks and uncertainties involved 
in their particular firm. The theory of probability is well de- 

51 



Contemporary Corporate Accounting and the Public 

veloped and its applications in the type of situation being dis- 
cussed here are becoming more and more understood. However, 
the conceptual and operational difficulties involved are so great 
that at the present time it is premature to recommend the present- 
value basis for accounting for corporate resources in reports 
and statements for interested outsiders. Present worth of future""" 7 

{""receipts can be accepted as the theoretically correct and de- 
sirable approach to resource valuation and at the same time re- 
jected on the practical grounds that at the present time it is 

^yjrtually im possible to implement in a satisfactory manner. _ 



III 

Because practical implementation of the theoretically cor- 
rect definition of capital and value as the present worth of re- 
sources held is not possible, one must look to other definitions. 
The three definitions of capital and value, each of which has 
some role either explicit or implicit in contemporary accounting, 
are monetary, purchasing power, and productive capacity. 

Monetary 

The most generally used and commonly understood defini- 
tion of value and capital is monetary. That is, the capital of a 
corporation is a stock of money or monetary equivalents of other 
resources which has flowed into the corporation from creditors, 
stockholders, profitable operations, or other sources. The value 
of any of a corporation's resources would be equal to the amount 
of money given in exchange for them. This is the "value- 
equals-original-monetary-cost" convention which is deeply im- 
bedded in current accounting practice. Net income w r ould be 
realized only after the stock of monetary capital had been re- 
stored out of the revenue of the period. Put another way, net 
income would be equal to the difference between revenue 
earned and the original monetary cost of goods and services 
consumed in producing the gross revenue. 

For the most part, implementation of the monetary definition 
of capital and value is extremely simple. One works primarily 

52 



VALUE AND CAPITAL 

with the record of money or money obligations given or re- 
ceived. In the case of income determination one must deal with 
the problem created by the use of assets over relatively long 
periods of time. In these cases it becomes necessary to determine 
how much of the total value of the asset is a cost of a particular 
period. However, since total value equals total cost in this case 
the problem is somewhat simplified and, as suggested in Chapter 
Three, current accounting practice, which focuses its attention 
almost exclusively on income determination, results in balance- 
sheet values which are simply the residuals of original cost not 
charged against income. (This question is discussed at some 
length in Chapters Seven and Eight.) 

Purchasing Power 

The successive waves of inflation in the years after 1945 
directed much attention to what may be called the purchasing- 
power definition of capital. In this case the capital of a corpora- 
tion is viewed as being a stock of purchasing power, expressed 
in monetary terms, received from all sources. Thus, the value 
of any resource would equal the current purchasing power given 
in exchange for it. Net income would not be realized until the 
stock of purchasing power consumed in producing the gross 
income had been restored out of gross income. Net income 
would be equal to the difference between revenue earned in 
current purchasing power and incurred cost, which is defined 
as the monetary equivalent of the purchasing power consumed 
in producing the gross income. The determination of cost again 
involves the problem of long-lived assets, and in this case the 
cost for a particular period would simply be based on the cur- 
rent purchasing power equivalent of the original cost of the 
asset in question. 

The purchasing-power view of capital requires a regular 
revision of the value of resources held— at least to the extent 
that the purchasing power of money changes. At the time 
capital is received or committed to a particular use, money and 
purchasing power are equal. However, if money changes in 
value subsequently, the amount of purchasing power repre- 

53 



Contemporary Corporate Accounting and the Public 

sented by the capital, stated in monetary terms, will change. 
With 10 per cent inflation, for example, a particular resource 
which initially represented the giving up of $100,000 in purchas- 
ing power will now come to have represented $110,000 in pur- 
chasing power and the resource would be revalued accordingly. 
Changes in purchasing power may be measured by one of 
a number of general price-level indexes or by indexes specifi- 
cally based upon the corporation's own resources. The general 
arguments for and against the use of price-level indexes in ac- 
counting were presented in Chapter Four. Their use is not 
without difficulty both in terms of operation and of understand- 
ing, but it is essential to an implementation of the purchasing- 
power definition of capital. 

Productive Capacity 

A corporation's capital may also be defined as a stock of 
productive capacity. Productive capacity is not used here in the 
narrow sense of making things but in the broader sense of acquir- 
ing, manufacturing, and distributing goods or services. Such a 
view postulates that the capital of a corporation is a stock of 
resources— money, inventories, facilities, manpower, etc.— which 
came into the corporation from the usual sources— creditors, 
stockholders, profitable operations, etc. In this view, the value 
of any particular resource or the value of all resources is repre- 
sented by the amount of money currently required to replace 
them. There would be no net income until the stock of pro- 
ductive capacity consumed had been restored out of the gross 
income. Put another way, the costs of producing the revenue 
earned would be the cost of replacing the goods and services 
consumed. Costs arising from the use of long-lived assets would 
in this instance be based on the current replacement value of the 
asset used. 

Implementation of this definition of capital requires the re- 
statement of monetary equivalents whenever the replacement 
cost of a resource changes. Replacement cost cannot be measured 
with the simple precision characteristic of the measurement of 
historical monetary values. In the latter case a receipted bill 

54 



VALUE AND CAPITAL 

establishes value once and for all. For those resources regularly 
bought and sold in an established market, replacement value 
is as easy to establish as is current market price. For resources 
such as land and buildings, replacement value can be estimated 
quite readily by qualified appraisers. In some instances, indexes 
of labor and material and other costs may be the basis for an 
estimate of replacement value. 

IV 

The competitive-capacity view of capital and its twin, the 
replacement-cost view of value are, of the three different defini- 
tions of capital and value, the most appropriate for current use 
on both theoretical and practical grounds. On theoretical 
grounds replacement cost has validity because in general the 
current price at w hich a ny p articular r esource is be ing bought 
and sold sho uld give a fair approximation of its present worth to 
either buyer or seller. (This generalization must be somewhat 
modified by the existence of differing utilities. A lathe may have 
greater value for a machine shop which is rejecting orders be- 
cause of lack of capacity than for a machine shop which is under 
capacity.) In those instances where replacement value must be 
estimated, the basis on which the estimations are made must 
contemplate the existence of buyers and sellers, which inevitably 
involves approaching present value. There are, of course, some 
instances where the resource in question is quite irreplaceable- 
such things as brand names, exclusive distribution systems, and 
the like, for example. In these cases, the idea of productive ca- 
pacity, as defined, is not irrelevant but the replacement-cost 
definition of value is irrelevant and resort must be had to other 
approaches. It will be suggested in Chapter Eleven that in such 
instances there is no effective substitute for present worth. With 
these exceptions, however, replacement cost has considerable 
theoretical validity because it approximates present worth. 

The productive-capacity definition of capital also seems to 
be quite appropriate to the view of the contemporary corpora- 
tion as a vital and continuing part of society. It is inconceivable 

55 



Contemporary Corporate Accounting and the Public 

at the present moment that organizations such as General 
Motors, General Electric, General Dynamics, General Foods, 
or General Mills, for example, are not a permanent part of the 
contemporary scene. Ownership may change but the organiza- 
tions themselves will continue to pour out automobiles, toasters, 
airplanes, Jello and Wheaties; they will continue to provide 
thousands of jobs; they will pay taxes; they will make contribu- 
tions to education and charity. Short of the extinction of or a 
sweeping change in American society, these and many others 
like them will continue because what they do is, in a sense, the 
lifeblood of that society. It is quite reasonable therefore to define 
their capital as the resources necessary to do these things; and 
since this view of capital is implemented by the use of replace- 
ment cost, the latter is an appropriate basis for accounting for the 
large modern corporation. The replacement value of its resources 
is an appropriate basis for appraising its status. If its continued 
operation is in the public interest, its capital can only be con- 
ceived of in terms of the money required to maintain that opera- 
tion. 



Acceptance of the productive-capacity view of capital and, 
thus, the use of replacement cost does not eliminate the need for 
the adjustment of dollar values to account for changes in pur- 
chasing power. The principal reason is that replacement cost is 
not relevant in the case of financial resources— cash, monetary 
investments, and receivables. In addition, purchasing-power ad- 
justments may, on occasion, provide an administratively simple 
substitute for determination of replacement cost. 

Changes in the general price level will, of course, be re- 
flected in the changes in the price of any particular good or 
service and therefore replacement cost implicitly includes any 
changes in general price levels. However, one does not replace 
cash or securities or receivables in the sense that inventories or 
plant are replaced. That is, the face value of monetary resources 
would, at any given point, be replaced with exactly the same 

56 



VALUE AND CAPITAL 

face value, and thus to state their replacement value is a mean- 
ingless act. (The realizable value of receivables, for example, 
may be less than their face value, but this is a different problem 
which can be taken care of by the traditional allowance for 
doubtful accounts.) 

For the most part, cash and receivables turn over rapidly 
enough to keep more or less current with changes in the purchas- 
ing power of money. If monetary investments are in readily 
marketable securities, the current market price of the securities 
will probably discount whatever inflation has taken place while 
the securities have been held. If the monetary investments are 
not readily marketable, there is no such easy guide to their 
purchasing-power equivalent. However, unless monetary value 
has been absolutely stable during the accounting period, there 
will have been some change in the amount of monetary capital 
necessary to support a given level of these financial resources. 
The corporation's productive capacity depends as much on 
financial resources as on inventories and production equipment 
and therefore the monetary capital necessary to support the 
capacity should be shown. It will be fully shown only if corpora- 
tion's capital is adjusted for changes in purchasing power of the 
resources held. 

It should also be pointed out that only with such adjustments 
will the full result of the corporation's financial policy be made 
clear. For example, when the capital supporting certain resources 
is obtained through debt to be repaid during a period of inflation, 
the corporation will, in fact, have given up less purchasing power 
to acquire those resources than if it had paid for the resources 
with funds obtained from profitable operations in the past. 

In Chapter Eight, the problem of determining replacement 
cost of fixed assets and the question of frequency of adjustment 
will be discussed. For the moment it is sufficient to suggest that 
the administrative problems of determining replacement cost 
each year may be substantial. In such a case, the adjustment of 
these values for changes in the general price level (which should 
be much easier to do) will take up much of the spread between 
historical cost and replacement cost. For relatively short periods 

57 



Contemporary Corporate Accounting and the Public 

of time adjusted historical cost will, in many cases, approximate 
replacement cost. 

All resources are affected by inflation (or deflation) though 
the extent of the effect is in large part a function of the time 
over which the resource is held. Replacement cost (which in- 
cludes the effect of changes in the general price level) is only 
relevant to certain resources, and practical considerations may 
preclude frequent adjustments to replacement cost. However, 
the total amount of monetary capital required to maintain the 
purchasing power of all of the corporation's resources is a 
vital fact about the corporation's status and progress, and ad- 
justment of capital for changes in price levels must be made. 

VI 

The conventions of realized income and unrealized income 
are frequently encountered in accounting practice and literature. 
Essentially, the terms are intended to distinguish between in- 
creases in capital arising through sale of goods and services 
(realized income), and those related to resources still held (un- 
realized income). These conventions have not been considered 
here because they are relevant only if one defines capital and 
value, and thus income, in purely monetary terms. 

If capital is thought of as a stock of competitive capacity, 
there will, of course, be changes in the monetary equivalent of 
the stock of capital. (The changes may, of course, be increases 
or decreases though only increases— the usual conditions today- 
will be considered here.) These monetary increments will appear 
in the corporation's statements and it is necessary to recognize 
that these amounts are not income nor are they increases in 
capital. They are nothing more than the monetary equivalents 
of an existing stock of competitive capacity. If the capital of 
the corporation (in competitive capacity) is to be maintained 
these monetary "increases" cannot, of course, be withdrawn 
without impairing capital. The "monetary" increase does not 
mean that the income of the corporation has increased. If capital 

58 



VALUE AND CAPITAL 

and therefore cost are defined in terms of replacement cost, all 
income is realized. 

Much the same can be said about the traditional distinction 
between income and capital gains. Increases in capital arising 
from the sale of the corporation's regular products and services 
are income. Increases in capital arising from the occasional sale 
of the corporation's productive facilities, for example, are capital 
gains. Such capital gains can only arise for two reasons: the 
corporation has resources not accounted for, or some of its re- 
sources are not properly (i.e., currently) valued. If resources 
were valued in terms of present worth, the latter type of capital 
gain would be virtually eliminated. The only time an asset could 
be sold for more than its present value to the holder would be 
when, for some reason or other, it would produce greater future 
receipts in the hands of another. To the extent that replacement 
cost is a reasonable substitute for present value, the same situ- 
ation will exist. Capital gains arising from the sale of unrecorded 
assets are a different problem and suggestions for dealing with it 
are discussed in Chapter Eleven. 

These matters will require a good deal of explaining, be- 
cause they require a revision in the traditional way of thinking. 
In the broadest sense there are only two sources of capital, how- 
ever capital is defined: investment from outside the corporation 
and from increases generated by the corporation. Thus, in the 
monetary view of these matters all money increases not ac- 
counted for by new investment arise from income or capital 
gains. It consequently becomes necessary to explain that with a 
different view of capital this generalization is not valid. Capital 
may not have increased; only the monetary equivalent has in- 
creased. 

As stated in another connection, such problems must not be 
allowed to stand in the way of desirable change. There must be 
careful explanation by those preparing statements, and sincere 
effort to understand the explanation by those who read the state- 
ments. Unless one assumes these are possible, one assumes there 
can be no progress. 

59 



Contemporary Corporate Accounting and the Public 

VII 

The concept of capital as a stock of productive capacity quite 
easily shades over into what might be called the competitive- 
capacity view of capital. In this case, the corporation is viewed 
as having a certain position in its particular markets. Its capital 
is the monetary equivalent of the resources required to maintain 
that position, and it earns net income only after the costs of 
maintaining the position have been met from gross income. In 
a stable economy the competitive-capacity capital would be the 
same as the productive-capacity capital, but in a growing econo- 
my the former would provide not only for the replacement of 
existing productive capacity but for any additional resources 
required to maintain the company's competitive positions as well. 
Capital, in other words, would be the monetary equivalent of 
the corporation's stock of competitive capacity and no net in- 
come would be realized until the costs of anticipated growth had 
been met from realized gross income. 

Historically, these costs of growth have been thought of as 
coming out of profits rather than as costs to be deducted before 
calculating profit. However, it is possible this is a matter of 
words only; that from the point of view of investors, manage- 
ment-directed reinvestment of profit is not, in a practical sense, 
profit at all. For example, in the steel-price controversy of April, 
1962, the chairman of the United States Steel Corporation de- 
fended a proposed price increase as necessary "to help finance 
improved machinery, equipment and other productive facilities 
and research efforts, and to arm the corporation to keep in the 
competitive race.' 71 Since there is obviously no intention on the 
part of management in this case, and in most cases, to distribute 
at least a portion of so-called profits to shareholders, it is not 
unreasonable to label these sums as de facto costs, and to think 
of them as a permanent part of the corporation's capital. 

(If the capital necessary to support growth is distributed as 
dividends, growth can only come by raising new capital. In 
the traditional view of these matters, it is generally maintained 



*New York Times, April 22, 1962, p. lOf. Emphasis supplied. 

60 



VALUE AND CAPITAL 

that a corporation should "meet the test of the market" and 
raise new funds to finance growth. It is not generally held that 
new funds should be raised simply to maintain the status quo. 
If one thinks in terms of maintenance of present competitive 
position, growth is required to maintain the status quo of the 
individual corporation when the whole market is growing.) 

Implementation of this definition of capital would be ex- 
tremely difficult in many instances. There is no particular prob- 
lem where commitments have already been made— as in the case 
of research programs and promotional campaigns. Where com- 
mitments related to necessary growth have not been made and 
when there are only plans to build factories or distribution sys- 
tems, to increase working capital, to hire a new and more ex- 
pensive but "growth-minded" president one obviously gets 
involved with a great deal of subjectivity and uncertainty. On 
the other hand, if growth is the foremost consideration of 
corporation managers, there is no denying the relevance of this 
view of capital nor the desirability of having such information 
available. Finding suitable means for doing thus must be high 
on the agenda of those concerned with accounting for the large 
modern corporation. 



VIII 

Before leaving the subject of capital and value it should be 
observed that in actual practice contemporary accounting pro- 
cedures are a melange of all the views described here. LIFO- 
inventory valuation is a close approximation of replacement 
cost and thus of the productive-capacity concept of capital, 
though only in connection with income determination. The use 
of so-called accelerated depreciation is an attempt to account for 
income, in the short run, in the purchasing-power concept with- 
out actually adjusting monetary values. What has been called 
the competitive-capacity concept is not usually thought of as 
having a place in accounting, but surely many expenditures in 
research and development are made solely for the purpose of 
maintaining competitive position. Vast sums of money are know- 

61 



Contemporary Corporate Accounting and the Public 

ingly and willingly spent on investigations which cannot possibly 
begin to yield net income until relatively far into the future. 
Many promotional expenditures and charitable donations also 
fall into this category. All these represent money spent today in 
order to enhance or protect the firm's competitive position in the 
future, and all these expenditures are normally deducted from 
current realized gross income in order to determine current net 
income. 

It is true that these illustrations apply only to income de- 
termination, but this is only an indication of accounting's pre- 
occupation with that phase of its total activity. The fact is that 
all these definitions of capital and value are used in contemporary 
accounting. 

The use of replacement cost (as a practical substitute for 
the theoretically correct present worth) in measuring value 
would meet many requirements for accounting for the con- 
temporary large corporation. It would eliminate most of the 
aberrations resulting from the changing value of money. It 
would give a reasonable measure of the extent to which the 
corporation has maintained its relative position, which seems to 
be what most managements are striving to do. It would divert 
attention from the largely irrelevant past and focus it on the 
present and, to a degree, the future. It would make the balance 
sheet a much more meaningful statement of the capital currently 
committed to the corporation and thus make possible a reasonable 
assessment of the effectiveness with which the capital is being 
employed. In short, it would provide, much more than does 
historical cost or a melange of widely differing definitions, a 
solid and useful basis for appraising the status and probable 
progress of the contemporary corporation. 



62 



INVENTORY ACCOUNTING 



i 

During a period of time a business purchases or produces 
goods for sale, and in the typical situation some of those goods 
will have been sold during the period and others will still be 
held by the business at the end of the period. The essential ac- 
counting problem is the valuation of the goods manufactured or 
purchased. The value given to the goods still held is an important 
part of the corporation's capital. The value given to the goods 
sold is an important factor in the determination of income. Thus 
inventory accounting is an important element in all aspects of 
corporate financial reporting. 

Inventory accounting illustrates virtually all of the prob- 
lems and weaknesses of contemporary accounting. Because the 
accepted methods of inventory valuation are many and most 
varied, inventory accounting is an important cause of the lack 
of uniformity which so severely limits the utility of contempo- 
rary financial statements and reports. The almost exclusive at- 
tention given to income determination in recent years is vividly 
illustrated by the development of certain inventory-accounting 
techniques, and in no other instance are the frequently mean- 
ingless resource valuations which result from this exclusive atten- 
tion to income more obvious. 



^ost of the discussions in this book are relevant to all corporations. The 
material in this chapter is relevant only to those corporations engaged in 
buying or manufacturing and selling goods of one sort or another. Corpora- 
tions providing financial or other services do not have inventories in the 
usual sense of the word. 

63 



Contemporary Corporate Accounting and the Public 

It is important again to draw attention to the constant change 
which marks our recent decades and is implicit in all the discus- 
sions of this book. Virtually none of the problems of inventory 
accounting to be discussed would be problems in the event of 
prolonged and absolute economic stability; nor would they be 
problems if the nature and scope of the responsibilities and ob- 
jectives of corporations were still as they were in the earlier 
days of the century. Since it is unlikely that we will achieve 
(indeed, that we want) economic stability and since it is certain 
that we cannot return to the age of normalcy, the changed and 
the changing must be accepted and inventory accounting de- 
signed to accommodate them. 

II 

For the most part, contemporary accounting for inventories 
is based on the monetary-cost view of capital or original-cost 
view of value. It is generally conceived of as a problem of ac- 
counting for the monetary cost of the resources (labor, ma- 
terial, services) expended during a period of time to acquire 
goods for sale. 2 The task of accounting is to divide the total pool 
of expended resources or costs between the acquisitions sold 
(cost of sales) and the acquisitions still held (inventory). A 
conflict between income determination and resource valuation 
is implicit in this procedure for if the accountant is primarily in- 
terested in income determination he will make his allocation of 
incurred costs in terms of achieving the "best" measurement of 
cost of sales and, from that, net income. Inventory value will 
be essentially the residual of incurred cost. On the other hand, 
if the accountant is concerned with the "best" inventory valu- 
ation, income will be the residual. (Given the emphasis on in- 
come determination, the latter situation is most unlikely to 
occur.) 

In the first instance, of course, both inventory and cost of 
sales are based on quantities: quantities of goods held and quanti- 



2 For the sake of simplicity, the term "acquisition" will be used in the balance 
of this chapter to describe all goods— purchased or manufactured— made avail- 
able for sale or for further processing. 

64 



INVENTORY ACCOUNTING 

ties of goods sold to customers. In a sense, the value of inventory 
and cost of sales are a function of these quantities, but when- 
ever there has been a change or changes in the cost of acquiring 
the goods during the period, the cost to be allocated to each 
of the quantities remains to be determined. There are many 
methods for allocating acquisition cost to inventory and to 
cost of sales, but virtually all are variations on one of four basic 
procedures: specific identification; average cost; first-in, first- 
out (FIFO); last-in, first-out (LIFO). 

Specific Identification 

The obvious way of allocating the cost of acquisitions be- 
tween cost of sales and inventory is by specific identification. 
That is, the cost of acquiring the specific goods held in inventory 
becomes the value of the inventory and the balance of total 
acquisition cost becomes cost of sales. However, except in re- 
tailing it is not common (and frequently not possible) to keep 
track of the actual costs of acquiring specific units in inventory. 
Consequently, specific identification is limited to situations where 
acquisition costs for specific items are recorded or can be traced 
back. Furthermore, because of income tax and other advantages 
arising from the use of other methods— particularly LIFO— 
specific identification is not necessarily used as a basis for inven- 
tory accounting even when it is practical to do so. 

First-ln, First -Out 

The FIFO method of inventory accounting rests on the 
premise that the first unit acquired was the first one sold and, 
conversely, that the last unit acquired is held in inventory. The 
logic of the FIFO method is that it follows what is in a great 
majority of cases the actual movement of goods, for the oldest 
acquisitions are usually used first. It must be understood, how- 
ever, that when FIFO is used for inventory accounting the 
first-in, first-out assumption is retained even if the actual flow 
of use differs. 

In terms of cost, FIFO results in the most recent cost of 
acquisition being used as the value of inventory. Cost of sales is 

65 



Contemporary Corporate Accounting and the Public 

equal to the balance of incurred cost. (If all the inventory on 
hand exceeds the amount acquired at the most recent cost, the 
next most recent cost, and so on, would be used until all the 
inventory had been valued. (See Table A.) 

It is apparent that FIFO will in many instances result in an 
inventory valuation which will approximate current replacement 
cost. How close the approximation will be will depend on the 
rapidity with which costs change and the rapidity with which 
inventory turns over. In the illustration, the cost of acquisition is 
$200 at December 31, and so most of the inventory is valued 
at replacement cost. On the other hand, FIFO cost of sales will 
be different from the corporation's current acquisition cost. 
Again, the magnitude of the difference depends upon the re- 

TABLE A 

Illustration of Three Methods of Inventory Accounting 

Part II of this table shows the calculation of inventory value, cost 
of sales and gross profit following the three methods of inventory 
accounting described in the text. The assumed facts on which all 
three calculations are based are given in Part I. The reader will ob- 
serve that a steady increase in price levels is one of the assumed 
facts, a state which seems most relevant to our times. With de- 
creasing price levels the differences in results would be the same, 
but the relationship among the methods reversed: that is, FIFO 
would yield the lowest inventory value, highest cost of sales, etc. 
Selling price is assumed to be a more or less constant markup on 
current acquisition costs. 

I. Record of Inventory, Acquisitions and Sales for Year 19—. 

Cost per 
Quantity Unit Total Cost 

On hand-Jan. 1 12,000 $150 $1,800,000 
Acquisitions: 

From To 

Jan. 1 Mar. 7 8,000 165 1,320,000 

Mar. 8 May 24 14,000 170 2,380,000 

May 25 Aug. 17 13,000 175 2,275,000 

Aug. 18 Oct. 4 10,000 190 1,900,000 

Oct. 5 Dec. 31 13,000 200 2,600,000 

Sales 56,000 11,760,000 (selling price) 

On hand 14,000 (see Part II) 

66 



II. 



INVENTORY ACCOUNTING 

Inventory Value, Cost of Sales and Gross Profit for 
Year Ending December 31, 19— 



A. First-In, First-Out 


C. Last-In 


First 


"-Out 


Inventory 




Inventory 






13,000 units x $200 


= $ 2,600,000 


12,000 units x 


$150 


= $ 1,800,000 


1,000 units x 190 


= 190,000 
= $ 2,790,000 


2,000 units x 
14,000 units 

Cost of Sales 


165 


= 330,000 


14,000 units 


— $ 2,130,000 


Cost of Sales 






12,000 units x $150 


= $ 1,800,000 


6,000 units x 


$165 


= $ 990,000 


8,000 units x 165 


= 1,320,000 


14,000 units x 


170 


= 2,380,000 


14,000 units x 170 


= 2,380,000 


13,000 units x 


175 


= 2,275,000 


13,000 units x 175 


= 2,275,000 


10,000 units x 


190 


= 1,900,000 


9,000 units x 190 


= 1,710,000 


13,000 units x 


200 


= 2,600,000 


Total 


$ 9,485,000 


Total 




$10,145,000 


Sales 


11,760,000 


Sales 




11,760,000 


Gross Profit 


$ 2,275,000 


Gross Profit 




$ 1,615,000 


B. 


(Weighted) / 


iverage Cost 






Total Cost = 12,275,000 = $175.35 


approximate average cost per unit 


Total Units = 70,000 








Inventory - 14,000 x $175.35 = 


$ 2,455,000 (approximate 


) 


Cost of Sales — 


56,000 x $175.35 : 


= $ 9,770,000 (approximate) 


Sales 




11,760,000 






Gross Profit — 




$ 1,990,000 






D. 


Sumi 


nary 








FIFO 


Average 




UFO 


Inventory 


$2,790,00( 


) $2,455,000 


$ 2,130,000 


Cost of Sales 


$9,485, 00( 


) $9,770,000 


$10,145,000 


Gross Profit 


$2,275,00( 


) $1,990,000 


$ 1,615,000 



lationship between inventory-turnover rate and the rate of 
change in cost. It is obvious that the costs deducted from gross 
income are an understatement of the costs required to maintain 
the same quantity of inventory at current price levels of cost, 
and in this sense, then, FIFO results in an overstatement of net 
income. If all of the "net income" thus determined were dis- 
tributed as taxes and dividends it is clear, all else being equal, 
that new capital from outside the corporation would be required 
to support the same level of inventory and operations. 



67 



Contemporary Corporate Accounting and the Public 

Average Cost 

The average-cost procedure is widely used in inventory 
accounting, probably because of its extreme simplicity and be- 
cause of it sidesteps the necessity to make assumptions about the 
flow of goods. Basically, the method involves only determining 
the average cost per unit of all units acquired. This average cost 
is multiplied by the number of units sold and the number of 
units held to give cost of sales and inventory respectively. (See 
Table A). Usual practice involves a weighted average to take 
account of different quantities acquired at different costs, as is 
done in Table A. In some instances, a moving weighted average 
is computed, basically by recalculating the average at each new 
acquisition. 

As is the case with most averages, the result is neither quite 
fish nor quite fowl. An inventory value computed from average 
costs will not, when acquisition costs have fluctuated, equal 
the current costs of the inventory. If costs have increased or 
decreased substantially over the period in question, the dif- 
ference between current costs of acquisition and the cost of 
the inventory may be substantial. By the same token, the cost 
of sales will not represent the actual cost of acquisitions sold. 
The use of the moving-average technique will, in a period of 
changing acquisition costs, result in inventory value being more 
nearly equal to its current value, which is to say that it will 
approximate the FIFO method. 

Last-In, First-Out 

The LIFO method is in all respects the exact opposite of 
FIFO. The most recent acquisitions are assumed to have been 
sold and the first acquisitions (or more specifically, the inventory 
on hand when the corporation first adopted the LIFO method) 
are assumed to be always on hand. For the most part this is not 
the way in which goods are in fact consumed, though there are 
some instances, such as a pile of ore at a mine head or a pile 
of coal at a power plant, where the first material placed in storage 
may still be at the bottom of the pile. 

LIFO results in a cost of sales which reflects most recent 



68 



INVENTORY ACCOUNTING 

costs. Thus LIFO tends to avoid any distribution as "net income" 
of capital required to maintain current inventory levels. How 
close LIFO cost of sales will be to the current cost of acquisition 
will depend on the relationship between the rates of inventory 
turnover and price-level changes. LIFO yields inventory values 
which bear little relationship to the present worth of the in- 
ventory. The longer the time between the adoption of LIFO 
and the calculation of inventory value the greater this difference 
will be, if price levels have changed steadily in the interim. 
In the illustration in Table A, LIFO inventory would, un- 
less its quantity changed, remain at $2,130,000. If the upward 
trend of price levels continued it would be not many years be- 
fore the then current value of the 14,000 units would be twice 
its accounting value. 

LIFO and Income Taxation 

There is probably no better illustration of the influence of 
income taxation on accounting procedures than that given by 
LIFO. In a period of rising prices it will most generally be ad- 
vantageous to utilize the LIFO method in calculating taxable 
income for, as illustrated in Table A, it will result in a lower 
taxable income and therefore in lower taxes. When LIFO was 
first introduced into tax regulations in 1938 its use was permitted 
only by a narrow range of industries, but in 1939 it was made 
permissible for any taxpayer including, for example, retail stores 
where specific identification of goods can readily be made 
and where the pattern of use is definitely not last-in, first-out. 
Because of its obvious advantages to taxpayers during periods of 
rising prices it is not surprising that LIFO has been adopted by 
more and more companies— especially when the post- World War 
II inflation became apparent. 

Tax regulations require that taxpayers using LIFO must 
also use it (and clearly state they are using it) in their regular 
financial statements. Thus the fact that the use of LIFO is quite 
widespread in corporate reporting is less an indication of its in- 
herent soundness as an accounting procedure than of its efficacy 

69 



Contemporary Corporate Accounting and the Public 

as a tax minimizer. As suggested in an earlier chapter, taxation 
reflects responsibilities and objectives and procedural require- 
ments of governments which have little relationship with the 
responsibilities and objectives and procedural requirements of 
individual corporations. Since it is these latter with which 
corporate accounting is concerned, it seems particularly un- 
fortunate that regulations for determining taxable income should 
dictate the procedures of corporate accounting. 

Ill 

There are two obvious criticisms of contemporary inventory 
accounting. One is its extreme permissiveness. The second is 
that except in a time of absolute stability it simply will not per- 
mit achievement of a reasonably relevant statement of asset 
values and reasonably relevant statement of income. 

No better example of the lack of uniformity discussed in 
Chapter Four can be found, for the wide range of "answers" 
made possible by conventional procedures to both inventory 
value and net income utterly destroys comparability. Further- 
more, interpretation of financial statements is often made even 
more difficult because except in the case of LIFO it is not uni- 
versal practice to indicate the method of accounting used. 
"Lower of cost or market" is not very revealing when several 
significantly different definitions of "cost" are possible. 

It seems obvious, when alternate accounting methods are 
so very different, that there should be one method more nearly 
correct than others. In this case, none of the methods is right if 
one conceives of Tightness in terms of current values. FIFO will 
be most nearly right in terms of inventory value. LIFO will be 
most nearly right in terms of income determination. Average 
cost will generally miss on both counts. The only effective way 
out of this dilemma is to discard the historical monetary-cost 
definition of capital and value as the basis for inventory account- 
ing. The use of replacement cost, which is based upon the pro- 
ductive-capacity definition of capital and value, is the soundest 
basis for inventory accounting. Replacement cost will eliminate 

70 



INVENTORY ACCOUNTING 

the effect of changing price levels on both inventory values and 
on cost of sales (income determination). It will indicate what 
an important resource is presently worth and will express income 
as a function of the current cost of maintaining that present 
worth. 

For the most part, replacement cost should not be difficult to 
determine. Except in unusual cases such as tobacco, wine, dis- 
tilled liquor and similar products whose production involves 
extensive aging, a current market price for raw materials and 
other purchased goods will exist. Current labor and other manu- 
facturing costs are readily ascertainable. 

The effect of the use of replacement cost in inventory ac- 
counting can only be compared with the effects of conventional 
methods if it is assumed that all the inventory is sold at one time 
on the last day of the year. Making this assumption, and using 
the data in Table A to illustrate, the following would be the 
facts. Current replacement value would be $200 per unit. There- 
fore, inventory value would be $2,800,000 (14,000 x $200) and 
cost of sales would equal $11,200,000 (56,000 x $200). Gross 
profit would equal $560,000. Reference to the summary of 
Table A will indicate that the difference between inventory 
on a replacement-cost basis and on the FIFO-cost basis is not 
great. On the other hand, LIFO cost of sales is the closest of the 
incurred-cost methods to cost of sales based on replacement cost. 
In contemplating these differences, the discussion in Chapter Six 
of the relationship between replacement cost and adjusted his- 
torical cost should be recalled. The acquisition costs given in 
Table A are in unadjusted historical dollars, and thus the dif- 
ference between the several measures based on incurred cost and 
on replacement cost is greater than would be the case if dollars 
were adjusted for the decline in purchasing power. 

Normally, of course, inventory is sold more or less regularly 
throughout the year. Consequently, the use of replacement 
value would require that cost of sales be based on current re- 
placement cost at the time of sale. Practical considerations may 
require that adjustments of cost of sales to current replacement 
cost be made on, for example, a monthly basis, thus creating a 

71 



Contemporary Corporate Accounting and the Public 

possible small margin of error. It is also possible that with the 
use of modern electronic accounting machines, the adjustment 
at the time of sale may not, in fact, be impractical. If inventory 
were adjusted to replacement cost at the time of sale, the differ- 
ences from FIFO inventory and LIFO gross profit would be 
less dramatic than these were in this somewhat artificial illustra- 
tion. The important fact, of course, is that both inventory value 
and income would be on a current basis. 



IV 

The foregoing illustrates quite specifically the difference 
between the monetary and productive capacity definitions of 
capital and value. Conventional accounting rests on the assump- 
tion that inventory is really money and that if revenues exceed 
the money cost of inventory sold there is net income. Replace- 
ment value rests on the proposition that the inventory is part of 
the corporation's capacity to do business; that without main- 
taining a given level of inventory the corporation cannot main- 
tain its position. Therefore, there is no net income until the 
cost of restoring the inventory sold has been met from revenues. 
LIFO is, of course, an attempt to define income in terms of 
competitive capacity while clinging to the words and symbols 
of original cost. It does not achieve this objective and further 
results in a completely irresponsible ignoring of the totally un- 
realistic resource values which result. A calculation of return 
on capital when LIFO has been used for some time will be 
grossly distorted. 

Use of replacement value will, of course, require a "write up" 
of monetary capital to the extent that replacement cost exceeds 
original cost. As explained in Chapter Six, this does not mean 
that there has been a "capital gain" or that "unrealized income" 
has been recorded. Capital, in this instance, is units of inventory. 
If the monetary equivalent of that capital has increased, it simply 
means that the amount of money required to maintain the 
corporation's capital has increased. Neither income nor capital 
gain is involved. Nearly all contemporary financial reports of 

72 



INVENTORY ACCOUNTING 

corporations refer, in one way or another, to "lower of cost or 
market" in connection with inventory. However stated, the 
phrase means that the inventory is valued at cost unless current 
selling price is lower in which case it is valued at that selling 
price. This rule of inventory accounting is basically a practical 
expression of the convention of conservatism and obviously con- 
flicts with the convention of consistency. If inventory account- 
ing is based on current replacement value, this rule becomes 
irrelevant because replacement cost cannot, by definition, ex- 
ceed current market or selling price. 



Virtually all management decisions about prices, changes in 
product lines, investments, etc. involve a comparison of ex- 
pected gross income and expected cost. In these situations, 
modern management makes what can be called marginal or 
incremental analyses. That is, in approaching any one of the 
decisions mentioned, the usual questions asked are, in effect, by 
how much will the total gross income of the business change 
and by how much will the total costs of the business change 
as the result of a particular decision. A comparison of these 
changes, of course, gives the change in net income which is a 
basic factor in the decision. 

The need to answer these questions has led to a great deal of 
study of cost behavior and to the breakdown of the total costs 
of a business into two broad categories: those which are basically 
a function of some particular activity and those which, in the 
short run, are basically a function of being in business. Material 
consumed in production is an example of the first category; ad 
valorem taxes on existing land and buildings illustrate the second. 
For purposes of this discussion, the first category will be called 
"activity costs," and the second, "time costs" (though this is 
done without prejudice to other names with which the reader 
may be familiar). 

The traditional approach to inventory involves the inclusion 
of all costs of production incurred during a time period in the 

73 



*^^sm 



Contemporary Corporate Accounting and the Public 

costs of the units produced. In essence total cost divided by total 
production equals unit cost. Cost of sales equals cost per unit 
multiplied by units sold and inventory equals cost per unit 
multiplied by units held. The use of FIFO, LIFO, etc. will 
complicate but not change the essence of this procedure which 
is that total cost of production will be equal to the unit cost of 
production multiplied by the number of units produced. 

Under direct costing only activity costs are associated with 
units produced and all time costs are charged off as a total. Thus, 
cost of sales equals activity cost per unit multiplied by units 
sold plus all time costs incurred. Inventory equals activity cost 
per unit multiplied by units in inventory. 

The difference between these approaches may be illustrated 
by reference to Chart A. The large square box represents total 
cost of production for the period which is divided horizontally 
to indicate activity costs (A) and time costs (T). 

CHART A 



1 


[ ( 








I \ 








1 ACTIVITY/ 


A] 


A 2 




r COSTS \ 






TOTAL COST OF/ 


J 






PRODUCTION \ 


| 








TJME ) 


T-l 


T 2 


' 


COSTS ) 










COST OF SALES 


INVENTORY 



TOTAL COST OF PRODUCTION 



74 



INVENTORY ACCOUNTING 

Under conventional cost accounting all costs would be allo- 
cated to units produced and therefore cost of sales would be 
equal to Ai + Ti. Inventory would be equal to A2 + T2. Under 
direct costing, cost of sales would be equal to Ai + Ti + T2 (T 
would not in fact be divided into Ti and T2) while inventory 
would be equal to A2. This does not mean that direct cost of 
sales will always be greater than conventional cost of sales. The 
relationship, in any accounting period, will depend upon the 
relationship of T2 costs of the previous period charged off in 
connection with inventory sold in the current period and T2 
costs of the current period. For example, in a period of very low 
production and relatively high sales following a period of high 
production and low sales, conventional cost of sales might well 
exceed direct cost of sales. 

There is no question that for essentially short-run decisions 
about price, product lines, etc., direct costing is most appropriate 
since it focuses attention on those elements which will change 
as a result of a given decision. Traditional "fully allocated" unit 
costs are confusing and often misleading and the process of de- 
cision making has been greatly improved by the general accept- 
ance of the idea of direct costing. This general acceptance has, 
in turn, led to constant demands for the use of the same basis 
for inventory accounting in published corporation reports and 
statements. 

There is no necessary inconsistency between direct costing 
and the replacement-value basis for inventory accounting 
previously recommended. Replacement cost should by definition 
be equal to the actual outlays of resources which would have to 
be made at the present time in order to acquire goods for sale. 
Time costs will, by definition, be incurred in the short run 
under any circumstances and therefore the cost of replacement 
will be the cost resulting directly from whatever activity is re- 
quired to replace the inventory. To the extent that direct cost- 
ing measures these latter costs, it is an appropriate basis for 
inventory accounting in published statements. 

It should be remembered that direct costing is only con- 
cerned with product costs. The issue is simply which of all of 

75 



■ ■. w^^—^mi^^^m 



Contemporary Corporate Accounting and the Public 

the costs incurred by a corporation will be included in product 
costs or defined as operating costs. Direct costing is based on 
the proposition that product costs are those costs which are 
directly incurred as a result of acquiring product. The essential 
soundness of this view is not affected by considering all costs 
as historical cost, current cost, or future cost. 



VI 

Inventory accounting illustrates many of the basic difficulties 
of contemporary accounting. LIFO is obviously an attempt to 
mitigate some of the effects of blind adherence to the monetary 
concept without departing from all of the other basic concepts. 
At the same time, LIFO well illustrates the overwhelming con- 
cern with income determination. The totally unrealistic resource 
values which it produces are generally ignored. Inventory ac- 
counting clearly illustrates the extent to which accounting is 
influenced by income-tax regulations. 

The toleration of widely (one might almost say wildly) 
different procedures for dealing with a single problem clearly 
illustrates the extent to which accounting has failed to meet its 
responsibility to provide comparable and understandable data 
on which an evaluation of the status and progress of corpora- 
tions can be based. The use of current replacement costs as the 
basis for valuing inventory on hand and for measuring cost of 
sales would go far toward providing data on the current status 
of corporations and on what resource commitments are involved 
in the maintenance of their position. It would further eliminate 
much of the confusion and ambiguity which surround conven- 
tional inventory accounting. 



76 



L^k cip ter C^iah t 

ACCOUNTING FOR 
FIXED ASSETS 

i 

Accounting for machinery, buildings, land, and the other 
facilities in which and with which business is carried on is 
without doubt the most contentious and most discussed area of 
accounting. One would guess that the words devoted in books, 
articles, speeches, etc. to accounting for fixed assets, as these 
resources are commonly described, have over the years equaled 
the words devoted to all other accounting topics. This over- 
whelming attention undoubtedly occurs because fixed assets 
usually involve relatively vast sums of money which are com- 
mitted for relatively long periods of time. Because of the length 
of these commitments, accounting for them is spread out over 
lengthy periods of time and thus becomes greatly affected by 
changing price levels, changing economic patterns, changes in 
technology, and changes in business objectives. Because large 
sums are involved, these changes often have significant effects 
on resource valuation and on income determination. Only the 
expert will get excited about accounting problems which, though 
intellectually challenging, involve only relatively minor amounts. 
When relatively large sums are involved even those with only a 
limited interest in corporations become involved. 

Accounting for fixed assets is probably the most confused 
and confusing area of corporate accounting. A profusion of 
recognized accounting procedures yield widely different results. 
Terminology differs significantly from one corporation to an- 

77 



Contemporary Corporate Accounting and the Public 

other and is frequently quite unclear. The conflict between 
corporate accounting and income-tax calculation is nowhere 
more clear than in this area, and attempts to resolve it have 
given rise to new accounting problems. These same tax regula- 
tions have been a principal reason for the increasing tendency of 
corporations to lease rather than purchase fixed assets, and this 
has created new and unresolved accounting problems. The re- 
luctance of accounting to change its procedures, to adopt a 
reasonable degree of uniformity, and above all to recognize that 
the great changes in the nature of corporate responsibilities and 
objectives require changes in the fundamental postulates about 
the role of accounting are most vividly illustrated by fixed-asset 
accounting. 

The objective of fixed-asset accounting is the same as that 
of all other accounting: to provide the best possible information 
on which to base appraisals of the status and progress of corpora- 
tions and to evaluate the extent to which they are meeting their 
apparent objectives. As suggested in earlier chapters, this objec- 
tive is most likely achieved by attempting to state the monetary 
equivalent of the corporation's current productive capacity and 
by recognizing as income the residue of current revenue after 
this productive capacity has been restored. With these data it is 
possible to determine how much the productive capacity of the 
firm has grown. A reasonable measure of return on capital em- 
ployed is also made possible, and this is a useful measure of the 
efficiency with which resources are being used. Finally, such 
data permit one to think about future prospects in terms of the 
current commitment of resources to the enterprise. 

Fixed-asset accounting, however straightforward its objec- 
tives, is extremely troublesome because most fixed assets will be 
used by the corporation which has acquired them over relatively 
long periods of time— almost invariably far longer than the con- 
ventional one-year basis of accounting. While it is relatively 
easy, for example, to determine the quantities of goods acquired 
during a year which have been sold or are still held, it is often 
impossible to do so with fixed-asset acquisitions. What "quan- 
tity" of a foundry, for example, has been sold (used up) or is 

78 



ACCOUNTING FOR FIXED ASSETS 

still held (available for future use) after a year has passed? It is 
this inevitable indefiniteness about some of the underlying 
phenomena being accounted for which gives fixed-asset account- 
ing its somewhat special difficulty. 

II 

Choosing from among the several definitions of capital and 
value described in Chapter Six is the central problem of fixed- 
asset accounting. In considering this choice, it is useful to utilize 
Canning's definition of assets as "future services." 1 The build- 
ings, machinery, equipment, etc. a corporation possesses are, in 
fact, the present material embodiment of future services. The 
assets are indeed goods, but the corporation owns them because 
of the service they will render in the future. Continued use of 
such an asset steadily reduces the amount of future service it 
represents. Thus the accounting problem is to state the future 
service potential represented by any particular asset, and to state 
as expense of any particular period the amount of service po- 
tential consumed in producing the revenue of the period. 

Both these facts are ideally expressed in terms of present 
value. The value of future service potential is clearly reflected 
in the present value of the discounted future earnings estimated 
from the use of the resource. The cost associated with the use 
of the asset is the value consumed, which is equal to the change 
in present value during the period in question. However, as 
suggested in Chapter Six the procedural and conceptual difficul- 
ties involved in the implementation of present worth are, at 
present, too great to permit the use of present value in published 
financial reports. 

Replacement cost seems to be a generally suitable substitute 
for present value in fixed-asset accounting. It is certainly a vast 
improvement over historical cost which in many cases will not 
even closely approximate the current value of future service 
potential, especially if an attempt is made to have costs include 



1 J. B. Canning, The Economics of Accountancy (New York: Ronald Press, 
1929). 

79 



ast=^ - IS^r- 



Contemporary Corporate Accounting and the Public 

a reasonable estimation of service potential consumed. Replace- 
ment cost is an indication of value today, not the largely irrele- 
vant past which is the basis for historical cost. If historical cost 
is adjusted for changes in price levels, the difference between 
it and replacement cost will usually not be great. However, the 
principal argument, stated earlier, for moving from adjusted 
original cost to replacement cost is that replacement cost is far 
more in keeping with the contemporary view of the corpora- 
tion as an on-going instrument for the production of goods and 
services and the rewarding of those who provide its productive 
capacity. The importance of such an instrument lies in its ca- 
pacity to produce both at present and on into the future, and 
a meaningful statement of the value of the productive capacity 
it currently holds must express the cost of maintaining it. 

The substitution of replacement cost for historical monetary 
cost will require, as in the case of inventory accounting, an off- 
setting adjustment in the statement of the corporation's capital. 
If one accepts the concept of capital as productive capacity, the 
rationale for the adjustment is clear. At the same time, the con- 
flict with traditional accounting usage must be recognized. All 
who have an interest in the distributable resources of the corpo- 
ration must recognize that the increase (or decrease) is, in effect, 
an increase (or decrease) in the capital permanently invested in 
the corporation. It represents a change in the monetary cost of 
the corporation's productive resources. It does not involve an 
increase in distributable resources. 

The use of replacement cost in fixed-asset accounting is un- 
fortunately not so straightforward as it is in accounting for 
inventories. The relatively long service lives of fixed assets, 
rapid technological change, and their frequently highly special- 
ized nature are factors which combine to make determination 
of replacement cost somewhat difficult. Broadly speaking, there 
are two approaches to determining replacement cost. 

In some cases, replacement cost can be thought of as the 
current cost of an asset of the same age and in the same con- 
dition. To illustrate, the replacement cost, in 1962, of a 1960 
model, two-ton Dodge truck would be equal to the current 

80 



ACCOUNTING FOR FIXED ASSETS 

market price of a secondhand, 1960 model, two-ton Dodge truck 
in comparable condition. The cost associated with the use of 
the truck during any period of time would be equal to the 
decline in its replacement cost during that period. Actually, 
the case of automotive equipment is one of the few instances 
where the active secondhand market necessary to determine re- 
placement cost in this manner actually exists. Consequently, its 
use is greatly restricted. 

The other approach to determining replacement cost (which 
does not depend upon the existence of a secondhand market) 
is based upon replacement cost new less the decline in service 
potential since acquisition. In this case, the replacement cost of 
the two-ton Dodge truck in 1962 would be the cost of a 1962 
model truck less the decline in service potential expected to 
accumulate over two years of use. The cost associated with the 
use of the vehicle during any period would be equal to the esti- 
mated decline in service potential. Implementation of this ap- 
proach to replacement cost obviously involves (1) determina- 
tion of replacement cost new and (2) estimation of the decline 
in the value of future service potential. These two problems 
are discussed in the following pages. 

Replacement Cost 

The most direct way of determining current replacement 
cost new is to utilize the current market price of comparable 
assets. For reasons given below there is no compelling necessity 
that the asset be an exact duplicate. Where this is possible, no 
further problems are encountered except for the matter of 
frequency of restatement also discussed below. In many cases, 
something more is required because changes in technology, de- 
sign, processes, etc. have been of such magnitude that even 
approximate duplicates are not available. In such instances resort 
must be had to specialized indexes of labor and material costs 
from which the cost of replacing the asset today can be esti- 
mated. This is not the same as an over-all adjustment of ac- 
counts for changes in the purchasing power of money generally. 
Individual indexes of construction and manufacturing costs 

81 



Contemporary Corporate Accounting and the Public 

would include differences arising from changes in methods, 
procedures, etc., as well as those arising from changes in general 
price levels. This difference is an expression of the difference 
between the productive-capacity definition of capital and the 
monetary view of capital. The use of replacement cost is not 
a device for accounting for purchasing power expended. It is 
not an attempt to account for the current cost of some former 
investments in productive capacity. Rather it is an attempt to 
account for the current cost of the corporation's current pro- 
ductive capacity. That the several artifacts which are the em- 
bodiment of that capacity cannot be exactly duplicated is not 
relevant. 

It must be acknowledged that the use of current replacement 
costs may, in some instances, involve an increase in current 
capacity. (The current model of a particular machine may have 
a higher output rating, for example.) In other words, the use 
of replacement cost may on occasion result in the inadvertent 
inclusion of costs of growth. This does not seem a serious matter 
when compared with the growth costs almost surely included in 
conventional accounting for research, promotion, contributions, 
and the like. And without doubt, carefully determined replace- 
ment costs will be much closer to current values than will his- 
torical cost. 

The use of replacement costs involves consideration of the 
frequency of restatement to current replacement cost. 2 The 
task of determining current replacement cost of the thousands 
of individual assets controlled by a large corporation is a formid- 
able one. (The general availability of high-speed computers 
may make it much less formidable. The Imperial Tobacco Com- 
pany of Canada which restated its fixed assets on replacement 



2 See Robert Sprouse and Maurice Moonitz, A Tentative Set of Broad Ac- 
counting Principles (Accounting Research Report Number 3). (New York: 
American Institute of Certified Public Accountants, 1962.) This monograph 
came into my hands after most of the writing of this book was completed. 
While my statements do not always agree with those of Professors Sprouse 
and Moonitz, their views are close to mine on many matters, even though 
our work was quite independent. At this point, however, I must acknowledge 
a specific debt to them because in my original draft I had ignored the ques- 
tion of frequency of change in replacement costs. 

82 



ACCOUNTING FOR FIXED ASSETS 

cost in 1961 has said that the job was possible only because of 
computers.) If accounts are adjusted annually for changes in 
general price levels, there should be no need for such frequent 
adjustments of replacement cost. In general, the difference be- 
tween adjusted historical cost and replacement cost should not 
be great until a few years have passed. Certainly, as Sprouse 
and Moonitz suggest, assets should be restated at replacement 
value whenever they are transferred from one owner to another. 
(See following chapter.) Beyond that, one can only suggest 
revision, say, every three to five years. Only careful study by 
individual companies will indicate where the spread between 
adjusted historical cost and replacement cost is great enough 
to require restatement to current replacement cost. 

Decline in Value 

The following discussion concerns the causes of decline, 
over time, of the future services represented by a fixed asset, 
the probable patterns of that decline, and the ways of account- 
ing for it. 

When a fixed asset is acquired it represents a stock of future 
services to the owning corporation. That stock of services is 
drawn upon as the asset is used and thus, as time passes, the 
stock of future services remaining grows even smaller. Since 
accounting must be based on monetary equivalents or values, it 
is most convenient to refer to this phenomenon as decline in 
value. Since the stock of future services declines over time, the 
value of the future services declines as well. 

In estimating the decline in value of a fixed asset two ele- 
ments are to be considered: the elapsed time until no value re- 
mains, and the pattern of the decline in value during that time. 
Each of these elements is a function of the underlying physical, 
economic, and social phenomena which are the basic causes of 
the decline in value. 

Useful Life. The span of time over which the value of a 
fixed asset declines and disappears is usually referred to as its 
useful life or its economic life. The useful life of a fixed asset 
in the hands of a particular owner lasts as long as continued use 

83 



Contemporary Corporate Accounting and the Public 

of the fixed asset is more profitable than some alternative. Con- 
versely, useful life ends when some alternative becomes more 
profitable than continued use of the fixed asset being considered. 3 
Broadly speaking, this condition will result from one of three 
factors. In the first case, the fixed asset may have reached a 
physical state where it can no longer be made to operate satis- 
factorily or where the cost of doing so is higher than the oper- 
ating costs plus capital costs of a replacement. The "wonderful 
one-hoss shay" is the extreme illustration of this. Secondly, the 
fixed asset may still function well but an alternative means for 
doing the same thing is available and the saving in operating 
costs is enough to justify purchase of the alternative means. 
Steam railroad locomotives— some of them nearly new— met this 
fate at the hands of diesel-electric locomotives in the late 1940's 
and early 1950's. Finally, the fixed asset in question may still 
be operable but the demand for what it produces has declined or 
disappeared. Many men's hat factories have become illustrations 
of this aspect of economic life. These second and third factors 
are usually lumped together under the single heading ob- 
solescence. 

Simply stated, then, the useful life of a fixed asset in the 
hands of its present owner is determined by the rate of physical 
deterioration of the fixed asset, by the rate of obsolescence of 
the fixed asset, or by the rate of obsolescence of the product or 
service in whose production the fixed asset is used. These rates 
of occurrence and the patterns they follow are the essential 
bases for measuring decline in value from which present value 
may be estimated. 

The Pattern of Decline. Physical deterioration is constantly 
going on. In the case of buildings and other structures the mere 
passage of time with the attendant effects of change of season, 
etc. will bring about physical deterioration and use will, of 
course, add to it. Use is no doubt the basic cause of the decline 



3 The fixed asset itself may still have economic usefulness to some other 
owner; trolley cars sold by defunct North American street railways to South 
American operators, and Northern textile mills used as supermarkets, ware- 
houses, electronics shops, and so on, are examples. 

84 



ACCOUNTING FOR FIXED ASSETS 

in value of machinery and equipment. Physical deterioration, 
whatever its cause, can be offset in substantial measure by re- 
pairs and maintenance, though there eventually comes a point 
where further repairs are not worth their cost. 

The ravages of time generally become increasingly difficult 
to offset. The cost of restoring service value grows steadily and 
therefore the remaining value, in effect, becomes progressively 
less as time goes on. This means that value declines more rapidly 
in the early part of the life of an asset. Furthermore, there is a 
general tendency to use newer and more efficient equipment 
first, leaving older equipment to meet peaks in demand, for 
stand-by, etc. To the extent that deterioration follows use, the 
same pattern of greatest decline in early life should follow. 
Generalizations about physical deterioration are always subject 
to qualification, but surely it results in a decline in value which 
is progressive, the one-hoss shay notwithstanding, and which will 
typically be greatest in the early years of an asset's life. 

Obsolescence is both progressive and sudden. Some obsoles- 
cence is always in the making as producers strive for marketable 
improvement in their products. Beyond this there is always a 
threat of sudden obsolescence as a result of new inventions or 
developments in the art or as a result of collapse in demand for 
the good or service produced by the fixed asset. The threat is 
there but the moment of occurrence, if any, is not known very 
far in advance. However, given present scope of industrial re- 
search and development with the resulting rapid changes in 
technology, and given the tremendous promotional and ad- 
vertising efforts put forth to change consumer preferences, it is 
reasonable to assume that obsolescence will occur in a great 
many cases, that it will occur fairly suddenly, and that the 
likelihood of occurrence increases as the fixed asset gets older. 

Recognition of Decline in Value. It can be concluded from 
the foregoing that the decline in value of fixed assets is in- 
evitable, but that which has taken place and, more important, 
that which will take place cannot be measured with any great 
certainty. On the other hand, if accounting is to provide useful 
information about the status and probable future of the corpora- 

85 



Contemporary Corporate Accounting and the Public 

tion it must provide fixed-asset valuations which recognize that 
decline in value has taken place and does take place. Further- 
more, proper determination of net income requires a recognition 
that some portion of current gross income simply represents the 
conversion of fixed assets into goods and services which have in 
turn been converted into gross income through sales. This 
portion of gross income is a part of the capital of the corpora- 
tion, and is not a part of net income. 

The phenomenon of gradual decline in the value of fixed 
assets must be recognized. Since, in most cases, it cannot be 
recognized exactly as it occurs, the question is whether this 
recognition should be made in a fashion which conforms as 
closely as possible to the probable pattern of decline in value, 
or should simply be made in the most convenient way on the 
grounds that it will be inexact at best. Both points of view are 
represented by contemporary accounting practice. 

(It is appropriate at this point in the discussion to recognize 
the term "depreciation" which is almost universally used in 
accounting to identify the process of accounting for the decline 
in value of fixed assets. It is unfortunate that the term is so used 
because it is widely misunderstood and the cause of much con- 
fusion. By definition, decline in value through physical deterio- 
ration and obsolescence is depreciation. Depreciation, as defined, 
cannot adequately be measured; it can only be approximated. 
The best that can be done is to estimate the extent to which the 
capital represented by fixed assets has been converted into other 
resources through manufacturing and sales. The use of a term 
such as "capital conversion" would not lead anyone to the con- 
clusion that actual depreciation was, in fact, being measured.) 

Depreciation Accounting 

Current accounting practice is rather ambivalent on the 
matter of the extent to which the actual pattern of decline in 
value should be approximated. The definition of depreciation 
accounting of the AICPA can support almost any approach. 

Depreciation accounting is a system of accounting which aims 
to distribute the cost or other basic value of tangible capital assets, 

86 



ACCOUNTING FOR FIXED ASSETS 

less salvage (if any), over the estimated useful life of the unit (which 
may be a group of assets) in a systematic and rational manner. 
Depreciation for the year is the portion of the total charge under 
such a system that is allocated to the year. Although the allocation 
may properly take into account occurrences during the year, it 
is not intended to be a measurement of the effect of all such 
changes. 4 

This definition clearly states in its final clause that deprecia- 
tion accounting does not attempt to measure the actual change 
in value which may have taken place, but gives little guidance 
as to whether or not it should attempt to approximate it. "Sys- 
tematic and rational" can be interpreted in about any way one 
wishes. As the following descriptions of the principal methods 
of depreciation accounting in use suggest, "systematic and ra- 
tional" does indeed mean all sorts of quite different things. 

While the definition above refers to "cost or other basic 
value," contemporary accounting practice concerns itself with 
acquisition cost in virtually all cases. However, the methods of 
capital conversion or depreciation accounting for historical cost 
are equally relevant to accounting for fixed assets which are 
stated at historical cost adjusted for changes in purchasing power 
or at replacement cost. In what follows, it should be under- 
stood that "cost" refers to replacement cost. As mentioned 
earlier, there are at least ten systematic and rational manners 
described in various works on the subject. However, many of 
these are simply variations on the same basic idea or are used 
only rarely in very special situations. Only the three principal 
methods in fairly widespread use will be considered here. 

Constant Deductions. By far the most common and the 
simplest method, usually called "straight line," is that which 
makes a fixed or constant annual deduction for depreciation or 
capital conversion. The procedure is extremely simple. Cost is 
divided by the estimated life of the fixed asset in years, the re- 
sult being a fixed annual deduction. The net value of the fixed 
asset declines proportionately each year and the same deduction 



4 American Institute of Certified Public Accountants, Accounting Terminol- 
ogy Bulletin Number 1, Review and Resume (New York, 1961), paragraph 56. 

87 



TZT 



Contemporary Corporate Accounting and the Public 

is made from gross income each year. (The annual deduction 
is often referred to as a rate— 10 per cent, 20 per cent, 12 x /2 
per cent, etc., but this is nothing more than presumably more 
convenient terminology. A 10 per cent rate simply refers to a 
ten-year life, etc.) 

The constant-deduction method emphasizes the distinction 
between attempting to approximate actual decline in value of 
a fixed asset and simply making a "systematic" deduction to 
recognize capital conversion. The previous discussion of the 
likelv pattern of decline in value suggested that it surely does 
not take place in equal annual decrements, and thus the fixed- 
amount method is not rational in terms of the decline in value 
of assets. Bv the same token, it does not satisfy the usual criteria 
for matching realized gross income and expense. The deduction 
for capital conversion will remain constant in the face of either 
lower or higher than normal volume of activity, which means 
that net income will fall more rapidly or rise more rapidly 
simply because of an estimated expense. Given the relationship 
between use and decline in value it is difficult to credit this 
procedure as rational. Indeed, its basic rationale seems to be 
that it gets done the job of making an annual provision for 
capital conversion in the simplest possible manner. Its operational 
convenience is no doubt the reason for its widespread use. 

Variable Deductions. A number of related procedures, 
usually referred to as user or production methods, relate annual 
deductions to the actual use of the fixed assets. The pattern of 
deductions obviously varies with use. The methods differ 
mechanically from the constant-deduction procedure only in 
basing the estimate of useful life on output or machine hours 
rather than on time. Cost is divided by the estimated life in units 
of use, the result being a fixed deduction per unit of use. The 
annual deduction is equal to the product of the fixed deduction 
per unit and the actual units of use. 

This procedure is often used in connection with transporta- 
tion equipment, for example. The useful life of an intercity 
bus can readily be estimated in miles and the periodic deduction 
for capital conversion or depreciation based on miles traveled. 

88 



ACCOUNTING FOR FIXED ASSETS 

This procedure obviously cannot be used in connection with 
most buildings and structures or with any other fixed assets 
which do not have a readily recognizable measure of use. 

If decline in value of future service potential is a function 
of use, this procedure, which relates accounting for decline in 
value to use, would seem to meet the requirement of rationality. 
If the estimate of the fixed asset's life in units is correct, this 
method would measure that aspect of decline in value precisely. 
On the other hand, it bears no relationship to the incidence of 
obsolescence and if the likelihood of obsolescence is at all great 
it will be an insufficient measure of decline in value. It is more 
efficacious than constant deductions in eliminating arbitrary 
fluctuations in net income. Since the annual deductions from 
realized gross revenue are a function of revenue (unless produc- 
tion and sales are not reasonably closely related) they should 
result, other costs not considered, in a more or less constant 
margin. 

Compared with the constant-deduction method, basing de- 
ductions on use is more difficult. Records of use (machine hours, 
production, etc.) must be kept and calculations of the annual 
deduction must await the end of the accounting year. The 
constant annual deductions can be calculated in advance at the 
moment of acquisition of the fixed asset. Nevertheless, the pro- 
duction or user method is suitably systematic and by basing 
capital recovery or depreciation provisions on the use of the 
fixed asset it does have a recognizable rationale. 

Decreasing Deductions. Several procedures for determining 
annual provisions for capital conversion or depreciation re- 
sult in deductions of steadily decreasing size over the life of 
the fixed asset. Two different ways of achieving this effect are 
in general use. 

The first of these, usually called declining balance or di- 
minishing balance, involves the application of a fixed rate per 
year (typically twice the fixed-amount rate) to the unconverted 
balance of cost. That is, the previous year's decline in value is 
deducted from cost before calculation of the deduction for the 
present year. Given an asset with an estimated life of ten years 

89 



Contemporary Corporate Accounting and the Public 

and costing $1,000, the deduction in the first year would be 
$200 ($1,000 x 20 per cent). In the second year, it would be 
$160 ($1,000 - $200 X 20 per cent); in the third year, $128 
($800 — $160 X 20 per cent), and so on. A feature of this 
procedure is that the full amount of cost is never completely 
deducted since the unconverted balance will approach but not 
equal zero. Because of this, the expedient of changing from 
declining balance to straight line after half the estimated life 
of the fixed asset has expired is frequently adopted. 

The second method is called "sum of the year's digits" and 
is simply an arithmetic device for obtaining successively smaller 
deductions. The annual deduction is a fraction of cost. The 
numerator of the fraction is the number of years of estimated 
life remaining at the beginning of the year; the denominator 
equals the sum of the number of years of estimated life. With 

a ten-year life the denominator would be 10 + 9 + + 

1 = 55: 10/55 would be the fraction for the first year, 9/55 
for the second year, 8/55 for the third year, and so on. A 
procedure which sounds so complex and has such a terrifying 
title should have some deep significance. "Sum of year's digits" 
has no significance other than resulting in successively smaller 
deductions, and doing so in a very arbitrary fashion, even though 
it appears quite scientific. 

These two decreasing-deduction methods have had great 
vogue since 1954 when they were first permitted in the calcula- 
tion of taxable income. There are other, perhaps more logical 
ways 5 of implementing the decreasing-deduction concept, but 
since these are the only ones permitted by the Internal Revenue 
Code, they are the only ones in frequent use. Prior to 1954, they 
were largely confined to accounting textbooks and examinations, 
probably because they are obviously more difficult to work with 
than is the fixed-amount method. 

In the preceding discussion of the probable pattern of de- 
cline of fixed-asset values, it was pointed out that the greatest 



°For an excellent and complete discussion of decreasing-amount deductions 
see Robert L. Dixon, "Decreasing Charge Depreciation— A Search for Logic," 
The Accounting Review, Vol. XXXV, No. 4 (October, 1960), pp. 590-97. 

90 



ACCOUNTING FOR FIXED ASSETS 

decline usually occurs in the early years of the fixed asset's life. 
The decreasing-deduction methods obviously reflect this pattern. 
Furthermore, since obsolescence is likely to occur before com- 
plete physical deterioration, and since the likelihood of obsoles- 
cence increases as the asset gets older, the decreasing deductions 
provide, quite incidentally, some hedge against both these possi- 
bilities. They do this, of course, by deducting the larger portion 
of cost during the early years of use. To the extent the new 
fixed assets are used more intensively, decreasing deductions 
should result in roughly the same pattern of deductions as those 
based on use. On the other hand, once the decreasing-deduction 
method has been put into effect the deductions are made an- 
nually according to schedule regardless of use. 

The great appeal of these decreasing-deduction methods in 
this day and age is that they generally result in larger current 
deductions and thereby lower current taxable income and thus 
a deferment of taxes which would generally have to be paid 
currently if fixed deductions were taken. (Recognition of the 
greater value of the bird in hand plus a usual inability to stop 
hoping for lower taxes make the deferment attractive.) In a 
period of price stability and constant size for a corporation, 
these relatively larger deductions would eventually be canceled 
out and the "advantage" of the decreasing deductions lost. 
However, with continued price inflation and especially with 
continued growth, the canceling-out effect of lower deductions 
is regularly postponed. As long as the corporation each year 
adds more fixed assets than it retires, the deductions under the 
decreasing-deduction methods remain high because of the high 
deductions associated with newly acquired assets. If the corpora- 
tion ceases to grow, the canceling-out process will eventually 
begin and if the corporation declines the process will be ac- 
celerated. 

Summary. All the methods of accounting for the decline in 
value of fixed assets held by the corporation are systematic; 
whether they are all equally rational depends upon what one re- 
gards as rational. It seems reasonable to insist that a rational 
method is one related as closely as possible to the actual pattern 

91 



Contemporary Corporate Accounting and the Public 

of decline in value. In most cases the causes of decline in value of 
future service potential— physical deterioration, obsolescence of 
the fixed asset, obsolescence of the product or service produced 
by the asset— combine to form a pattern of sharp initial decline 
followed by progressively smaller declines. Obviously, the de- 
creasing-deduction methods are the most faithful reflection of 
this pattern. (Whether either the declining-balance or sum-of- 
year's-digits procedures are logically rational or fortuitously so 
is a moot point. ) Deductions related to use are rational in those 
cases where sudden obsolescence is most unlikely to be an im- 
portant factor. Where it is reasonably certain that useful life 
will be a function of use, employment of these methods is sound. 
The only rationale for the widespread use of the constant-deduc- 
tions method appears to be simplicity. (One may suggest that 
general reluctance to change and the fact that a change to de- 
creasing deductions from constant deductions would initially re- 
sult in substantially lower net income are real, if not necessarily 
rational, reasons for continued use of constant deductions.) If 
one is primarily interested in income determination, this method 
does insure systematic deductions from realized gross income for 
capital conversion. It almost surely results in highly unrealistic 
resource values. 



Ill 

Fixed-asset accounting is no different from any other area of 
accounting in that it must be related to the role of the corpora- 
tion in society. This role revolves around the capacity to pro- 
duce goods and services and around the rewarding of those who 
provide the productive resources. Evaluation of performance in 
this role requires, therefore, information about the current value 
of the corporation's productive capacity, the resources required 
to maintain this capacity in the future, and the extent to which 
corporate operations are providing for the maintenance of that 
capacity and the rewarding of those who provide the productive 



'Ibid., p. 594. 

92 



ACCOUNTING FOR FIXED ASSETS 

resources. These broad requirements for accounting result in 
three specific requirements for fixed-asset accounting. 

Maintenance of the corporation's productive capacity re- 
quires that the current cost of fixed-asset replacement should 
be the basis for accounting. Secondly, the current value of fixed 
assets in use must be known. Finally, the existence of net in- 
come should be dependent upon the cost of current replacement 
being available from realized gross income. These requirements 
are theoretically met by valuing fixed assets at current replace- 
ment cost less accumulated decline in value and deducting from 
realized gross income the annual change in the difference be- 
tween these two. 

Decline in value of future service potential is correctly meas- 
ured by comparing the present value of discounted future earn- 
ings from future use of the fixed asset at two different points in 
time. The difference between these two present values is the true 
decline in that value. However, since this procedure cannot be 
implemented very satisfactorily at present, the more or less arbi- 
trary procedure which provides for annual deductions of de- 
creasing amounts should be used. It provides a reasonably accu- 
rate reflection of the typical pattern of true decline in value. 

Once again, it must be recognized that when the replacement 
value of fixed assets increases there will be a corresponding in- 
crease in monetary capital, an increase which is neither capital 
gain nor unrealized income. Capital in this instance is produc- 
tive capacity which has not increased. Only the amount of 
money required to maintain the corporation's capital has in- 
creased. Neither gain nor income is involved. 

Both current replacement value of fixed assets and the de- 
creasing-amount method of measuring decline in value are oc- 
casionally found in contemporary accounting. Unfortunately, 
many other procedures are also used and because of the large 
sums usually involved no better example of the deleterious 
effects of the extreme permissiveness of modern accounting can 
be found. For example, if a corporation acquired new fixed as- 
sets with a useful life of ten years at a cost of $10,000,000 during 
a year, the following accounting results (among many others) 

93 



mm^m^mm^i^mm 



Contemporary Corporate Accounting and the Public 

are possible. If constant deductions for decline in value were 
used, net income would be greater by $1,000,000 than if the 
declining-balance method were used. Also, at the end of that 
year the fixed assets would have an indicated current value of 
$9,000,000 in the first case and $8,000,000 in the second. 

Many people who have an important interest in corporate 
affairs are quite likely unwittingly to make wrong decisions, if 
the decisions are based on income data subject to such capricious 
variation. They will be further misled by contemplating the 
probable future of corporations on the basis of the value of its 
resources. Clearly, the same resources at the same time, dedicated 
to the same use by the same corporation, cannot be worth 
$9,000,000 and $8,000,000. They must be worth $9,000,000 or 
$8,000,000 or some other amount. 

Fixed-asset accounting involves the same conceptual and 
procedural problems as other areas of accounting. However, 
since the sums involved are relatively large and the time span 
relatively long, the need for resolution of these problems in ac- 
cordance with the widespread responsibilities and present-day 
objectives of the corporation is nowhere more apparent. 

IV 

DEFERRED TAXES 

Permitting the use of declining-balance or sum-of-year's- 
digits methods of providing for capital conversion for tax pur- 
poses has, when corporations have continued to use the straight- 
line method for corporate accounting, created an accounting 
problem of major dimension. The problem arises because the 
use of the different methods results in a difference between cor- 
porate income and taxable income in any particular year, even 
though the difference disappears over a period of time. 

In Chapter Five, the question of the relationship between 
taxable income and corporate income was discussed and it was 
suggested there that taxable-income calculations should not in- 
fluence corporate accounting. The problem being discussed here 
is somewhat different because the differences between the de- 



94 



ACCOUNTING FOR FIXED ASSETS 

preciation charges yield only temporary differences between tax- 
able and corporate income. For example, the exclusion of divi- 
dends received from taxable income of corporations is a per- 
manent exclusion (as long as tax regulations are not changed). 
The amount included in corporate income will never be includ- 
ed in taxable income. In the case of differing depreciation 
methods, the amount included in corporate income may, in any 
year, exceed or be less than the amount included in taxable in- 
come, but over the life of the asset the amount will be the same. 
(This assumes the same total amount being written off. If a cor- 
poration based its accounting on replacement cost while tax 
regulations permitted only historical cost there would be a per- 
manent as well as a temporary difference.) 

Before discussing the possible ways of accounting for this 
temporary difference between taxable and corporate income, it 
should be observed that the difference need not occur. That it 
does occur is a result of an apparent assumption that decreasing 
deductions for capital conversion are simply a tax "gimmick" 
and that fixed-amount deductions are in some way or other 
"right." Net income based on fixed-amount deductions is correct 
net income, it is assumed, while net income based on decreasing 
deductions is incorrect— an aberration tolerated for tax advan- 
tage. This assumption has no necessary validity because the de- 
creasing-deduction procedures have long been recognized as 
"systematic and rational" for estimating decline in value of fixed 
assets. Furthermore, these methods are not "gimmicks" since 
more than other methods they reflect the probable pattern of 
actual decline in value. If decreasing-amount methods of capital 
conversion were used for corporate purposes, and they provide 
the most rational approach in a great many cases, the difference 
would largely disappear. It would not necessarily disappear en- 
tirely, because there is no reason to assume that rates permitted 
for tax purposes are necessarily the appropriate ones for corpo- 
rate accounting. However, the differences might well be small 
enough to ignore. 

95 



S«»""^W»"*P^P 



Contemporary Corporate Accounting and the Public 

Most, though not all, accountants 7 maintain that proper 
matching of income and expense requires deducting from cor- 
porate net income the tax which would have been levied at the 
going rate on that net income, even though the tax actually paid 
was substantially different. The difference between this theo- 
retical tax and the actual tax paid would be added to a balance 
sheet account usually called "Deferred Income Taxes." In subse- 
quent years when the actual tax would normally exceed the 
theoretical tax the difference would be deducted from "De- 
ferred Income Taxes." In a completely stable situation where 
approximately the same monetary value of assets was being re- 
placed each year, where tax rates were constant and there was no 
inflation, this account would eventually stabilize at a sum roughly 
equal to the difference between the actual tax and the theoreti- 
cal tax in the first year. (Actually, the sum would not equal 
this amount unless depreciation already accumulated for tax 
purposes on assets held at the time the change over to the de- 
creasing charge basis for tax purposes was made, were adjusted 
retroactively to the new basis and adjusted from taxable income 
in the first year.) If the corporation is growing, the balance of 
"Deferred Income Taxes" will grow, as it will with steady in- 
flation. Deflation or a decline in the size of the corporation would 
have the opposite effect. If the corporation did not have taxable 
income in any year, the leveling off would not take place either. 
For the most part, the arguments against this accounting pro- 
cedure hang on the uncertainty that the theoretical conditions 
will ever be met. Future stability of tax rates, or for that mat- 
ter of tax regulations, future stability of monetary value, absence 
of either growth or decline for the corporation in question are 
all required by the assumption that the "saving" in income taxes 
today will be offset by corresponding "losses" in the future. 
Some contend these are highly uncertain assumptions about the 
future. 



"Ralph S. Johns, "Allocation of Income Taxes," Journal of Accountancy, 
Vol. 106, No. 3 (Sept. 1958), and Willard J. Graham, "Allocation of Income 
Taxes," Journal of Accountancy, Vol. 107, No. 1 (Jan. 1959). Accounting Re- 
search Bulletin No. 44 (rev.) states the official position in favor. 

96 



ACCOUNTING FOR FIXED ASSETS 

The principal argument for deferred-tax accounting is based 
on the requirement for proper matching of income and expense. 
It is held that failure to state net income for the year after theo- 
retical rather than actual taxes will overstate current net income 
on the one hand and not indicate that future net income, all else 
being equal, will be smaller. In other words, the deduction of an 
expense should be made from the revenue which resulted from 
the expense in accordance with the basic principle of accrual 
accounting. 

Accounting for deferred taxes may be supported on grounds 
other than income determination, for failure to account for them 
is a failure to recognize a liability of the corporation. Because 
the difference between the taxable and corporate-before-tax in- 
comes is only temporary, the tax is in fact deferred; it has not 
been avoided. Granted there is uncertainty, but the most likely 
thing is that it will have to be paid. Failure to recognize the 
liability, which means inclusion of the amount in net income, 
may result in the distribution, as dividends, of resources which 
will be needed to meet the liability in the future. 

It is important that the amount of the liability for future 
taxes be constantly reviewed in light of current and expected 
future conditions. If deferred-tax accounting is approached sole- 
ly as a matter of annual income determination, the liability be- 
comes simply an aggregate of past annual deductions from 
income, and in that case the arguments against accounting for 
deferred taxes cited above may well have practical if not theo- 
retical merit. Given this treatment, it is entirely possible that 
relatively huge paper liabilities will pile up; liabilities which be- 
cause of changes in tax rates or regulations, because of continued 
growth, because of operating losses or changed replacement 
rates will not come due in the foreseeable future. It is true that 
failure of the expected liability to materialize does not change 
the total amount of capital held by the corporation, but it does 
involve a shift from capital provided in effect by the govern- 
ment to capital provided by profitable operations, and because 
it is on this latter that claims for dividends, wage increases, price 
decreases, etc. are based, it is important that the shift be re- 

97 



Contemporary Corporate Accounting and the Public 

corded. Thus, the liability for deferred taxes should be reviewed 
annually and adjusted as necessary in light of changed condi- 
tions, past or current charges against income notwithstanding. 



ACCOUNTING FOR LEASED FIXED ASSETS 

American corporations have traditionally purchased most of 
the various facilities used in their operations, though some ma- 
chinery and such things as office space in big city office build- 
ings have been leased for use. These latter were leased because 
leasing was, for one reason or another, the only practical way 
of acquiring the needed facilities. Shoe machinery, for example, 
was until a recent court decision available only under lease. One 
obviously does not buy a fifty-floor office building to obtain a 
suite of offices. Except in these special cases, however, the almost 
universal procedures for acquiring fixed assets up to World War 
II was to purchase them outright with money borrowed for the 
purpose or with new or retained equity investment. 

In the years following World War II, there has been a rapid 
growth of leasing— particularly the so-called sale and leaseback 
—as a major method of financing fixed-asset acquisitions. It is im- 
portant that leasing in these cases is a form of financing rather 
than a necessary means of acquiring a particular facility. That is, 
there are no compelling reasons, other than financial ones, for 
leasing the fixed asset rather than purchasing outright. 

There are many reasons for this spread of leasing, but the 
basic attraction is undoubtedly lower taxes. The rental payments 
are generally based on the return of investment plus interest to 
the lessor over a somewhat shorter period than the estimated use- 
ful life of the asset. Since, for tax purposes, the actual lease pay- 
ments are a deductible cost, the taxpayer is in effect permitted a 
more rapid rate of capital conversion or depreciation than would 
be the case with owned assets. Furthermore, if the leased 
property includes land the lease payments will include the cost 
of the land, which means that the taxpayer is able to deduct an 

98 



ACCOUNTING FOR FIXED ASSETS 

allowance for capital conversion in the case of land— something 
not permitted with owned land. 8 

Fixed assets may be leased directly from their owners who 
have acquired them in order to lease, as in the case of leases of 
fleets of automobiles, trucks, etc. Most generally, with buildings 
for example, the corporation constructs the building to its own 
specifications and sells it to some financial institution which im- 
mediately leases it back to the building corporation. The device 
of the dummy corporation is increasingly a feature of leasing. 
In this case the leasing corporation creates a dummy corporation 
whose sole function is to acquire property and lease it to the 
main corporation. The dummy corporation sells bonds to in- 
vestors, bonds which are secured by the leases and interest in 
lease payments which it holds. The leases and related interests 
are assigned to a trustee by the dummy corporation who receives 
rental payments from the main corporation and makes the 
interest and sinking-fund payments on the dummy corporation's 
bonds. The common stock of the dummy corporation is entirely 
held by the leasing corporation, which means it controls the 
property after the bonds of the dummy have been retired and its 
leases reassigned by the trustee. Obviously this procedure is 
different only in its mechanics from the financing of fixed-asset 
purchases by a mortgage loan. 

Virtually all leases are noncancellable during a period some- 
what shorter than the useful life of the fixed asset. As mentioned 
earlier, the lease payments are designed to repay the lessors' 
capital plus interest over this same period of time. Usually the 
leasing corporation assumes responsibility for management of 
the property and all costs associated with it. Finally, there is a 
usual option to renew the lease or to repurchase at the expiration 
of the lease. 



8 For a full discussion of the advantages and disadvantages of leasing as 
well as all other aspects of the subject see the following, all in Volume 39 of 
the Harvard Business Review: Donald R. Gant, "Illusion in Leased Financing" 
(March-April, 1959); "From the Thoughtful Businessman" (July-August, 1959); 
Richard F. Vancil and Robert N. Anthony, "The Financial Community Looks 
at Leasing" (Nov.-Dec, 1959). 

99 



Contemporary Corporate Accounting and the Public 

The Accounting Problems 

The basic accounting problem results from the fact that 
traditional accounting principles provide no basis for the rec- 
ognition of the resources held by lease. Ownership, the essential 
requirement for the accounting recognition of the existence of 
resources, is not present. Legal claims against the resources of 
the company, the traditional basis for the recognition of debts, 
do not exist. Under traditional procedures, the only recognition 
of the lease is the deduction of the annual rental payment from 
realized gross income as an expense of the year. 

The important fact in connection with these leases is that, 
legalities of ownership notwithstanding, the corporation has 
basically unencumbered rights to use the fixed assets in question. 
An evaluation of corporate status and progress must be based 
on all the resources the corporation controls and on all the future 
commitments of resources resulting from that control. Assets ac- 
quired under long-term leases are, in fact, controlled by the 
corporation. Furthermore, since the fixed assets are presumably 
essential to the operation of the corporation, the lease payments 
are, in fact, future commitments, legalities notwithstanding. An 
adequate evaluation of a major oil company, for example, can- 
not be made if the information available does not include rec- 
ognition of several thousand service stations and the current 
value of those service stations simply because the corporation 
has leased rather than purchased them. (The inadequacy is even 
more pronounced if the service stations are owned by a dummy 
corporation.) Neither the law nor accounting procedures, both 
exclusively concerned with the ownership interest, can be per- 
mitted to act as barriers to adequate disclosure of important facts 
about the corporation. 

Many accountants have recognized this problem and recom- 
mend the inclusion, along with the corporation's owned fixed as- 
sets, of assets held under lease. It is generally recommended that 
the value of leased fixed assets be equal to the present value of 
future payments to be made under the lease, capitalized at a rea- 
sonable rate (the interest rate for the lease itself or an average 

100 



ACCOUNTING FOR FIXED ASSETS 

rate for all leases). The same amount is also included among the 
corporation's long-term liabilities. Both these amounts would be 
reduced as rental payments are made. The theoretically correct 
procedure is to reduce the two amounts by the amount of the 
principal payment with the balance of the rental payment being 
deducted from realized gross income as interest paid. 

Resolution of the problem of the dummy corporation is 
readily achieved by consolidation of its statements with those 
of its parent (e.g., the leasing corporation). With this procedure, 
no special accounting is required because the fixed assets would 
appear among consolidated fixed assets; the bonds would be in- 
cluded in consolidated debt; interest payments would be included 
in consolidated net income. 

These procedures are quite commendable as far as they go, 
for they do solve the problem of disclosure of resources and 
obligations. However, these procedures are based on the premise 
that assets acquired under long-term leases are no different from 
assets acquired by outright purchase. Since this is so, all of the 
arguments given earlier for basing fixed-asset values on replace- 
ment cost are equally valid here. The fact that a part of the 
corporation's productive capacity is financed by lease does not 
(except for somewhat lower capital costs) diminish the capital 
required to maintain that productive capacity. Similarly, the 
arguments in favor of recognizing decline in value by provisions 
of decreasing amount are valid here. The fact that financing 
the acquisition of the right to use fixed assets involves repayment 
in equal installments does not change the basic pattern of decline 
in value of the fixed assets. (The fact that repayment is made 
over a period somewhat shorter than estimated useful life clearly 
makes the repayment schedule an inadequate reflection of the 
actual decline in value.) The use of lease payments as the basis 
of value of leased assets is a reflection of preoccupation with 
historical cost. The idea of insisting on the disclosure of leased 
fixed assets is essential, but the basis for doing so should be re- 
placement cost less the best possible approximation of decline 
in value. 



101 



Contemporary Corporate Accounting and the Public 

VI 

ACCOUNTING FOR NATURAL RESOURCES 

Included among the productive resources of many corpora- 
tions are natural resources— base metals, coal, petroleum, miner- 
als, etc.— which are not normally replaceable. In one sense these 
resources are like fixed assets from an accounting point of view, 
because the value of the supply declines as it is consumed and 
converted into realized gross income. Sound resource valuation 
requires recognition of the decline in value and sound income 
determination requires recognition of the capital conversion. 
The difference between these wasting or depletable resources 
and fixed assets is the fact that the former are not replaceable, 
which means that the concept of replacement cost has no signifi- 
cance. 

Traditional accounting for these wasting resources is quite 
simple. The cost of the supply controlled— mine, well, quarry, 
etc.— is equal to the price paid for it if purchased, or to the costs 
of discovery and development when appropriate. The amount of 
the resource available from the supply controlled— tons, barrels, 
cubic yards, etc.— is estimated, and a cost per unit of the resource 
calculated. As the resource is used, the quantity extracted in a 
year is multiplied by this cost per unit and the resulting annual 
depletion allowance is deducted from the cost of the resource 
and, as a provision for capital conversion, from realized gross 
income. 

The real value of natural resources, as of all other resources, 
is the present value of future earnings from their use, appro- 
priately discounted. The price which happened to have been 
paid for them when they last changed hands will be a poor 
measure of present value unless the resources were acquired very 
recently. The costs of discovery and development will only by 
sheerest chance bear any relationship to present worth. Con- 
sequently, a complete and reliable accounting for natural re- 
sources held by a corporation should be based on present value. 
(Replacement cost obviously has no relevance in the case of 
wasting assets which are, by definition, irreplaceable.) 

102 



ACCOUNTING FOR FIXED ASSETS 

In general, the estimates of quantities of natural resources in 
a given source can be made quite accurately by geologists. Esti- 
mates of future earnings are subject to considerably more un- 
certainty because they depend on estimates of future prices, 
future costs, and especially the rate of use. Because most natural 
resources are for practical purposes imperishable, extraction can 
always await a satisfactory spread between selling price and ex- 
traction cost. Capped oil wells and closed coal mines all over 
North America are evidence of this fact. However, the deter- 
mination of present value does depend on an estimate of the rate 
of extraction and sale, and such estimates are inevitably uncer- 
tain. If it is expected that a proven reserve of oil, for example, 
will be sold at a given margin over extraction costs in twenty 
years, the present value of the reserve would be quite different 
from that with extraction and sale taking place over thirty years. 

On the other hand, the uncertainty involved in the estimate 
of the present worth of a supply of natural resources is more 
tolerable in terms of evaluation of corporate status and probable 
future than is the virtual assurance of being completely misled 
by values based on acquisition cost. For example, in 1956 the 
Gulf Oil Corporation sold its Canadian exploration and produc- 
ing subsidiary to the British- American Oil Company, Ltd. (a 
Canadian company in which Gulf had an important interest). 
The value of the net assets of Canadian Gulf, much of which 
were oil and gas reserves valued at acquisition cost, was stated 
at Can. $55,000,000. The selling price of these net assets, based 
on the market price of British- American shares, was Can. $355,- 
000,000. This latter figure was based on an estimate of the pres- 
ent value of the proven reserves of oil and gas held by Canadian 
Gulf. The difference between this figure and acquisition cost 
shows the wide margin of error permissable in the estimate of 
present value before it can even begin to be as obviously wrong 
and misleading as is value based on acquisition cost. 9 

As in the cases of fixed assets and inventory, basing the values 
of these natural resources on present worth will require under 

"British-American Oil Company, Ltd., "Annual Report for 1956." 

103 



Contemporary Corporate Accounting and the Public 

the rules of double-entry bookkeeping an offsetting balance. As 
in these other cases, this is only a problem if one thinks of capital 
in purely monetary terms. In that case, the increase (or de- 
crease) required to offset the increase (or decrease) in the pre- 
sent value of the resource will be considered as income (or loss) 
and taken to be available (if an increase) for distribution as 
dividends, wages, price cuts, etc. If one thinks of capital as the 
productive capacity of the corporation, this offsetting balance 
is simply a change in the monetary equivalent of that capital. It 
is the money required to maintain the existing capital of the 
corporation and there is no question of its being distributable 
income. 

Summary 

This chapter has been concerned with a number of somewhat 
different matters all having to do with resources which are held 
and used over fairly extensive periods of time and which typ- 
ically involve relatively large sums of money. These two factors 
illustrate vividly the effects on accounting of changes in price 
levels, in economic conditions, in technology, in the responsi- 
bilities and objectives of corporations. A particular accounting 
process which began in, say, 1955, and is still going on in 1962, 
must be based on the premise that many conditions have changed 
and will change. Basically, it can avoid misleading only if it is 
related to current conditions and current plans for the future. 
Accounting based on historical cost may be of relevance to the 
ownership interest. It certainly results in values which have little 
relevance to the current value of the resources or to any of the 
other constituencies of the corporation. 

The fact that large sums of money are usually involved in 
fixed assets magnifies the differences resulting from essentially 
free choice from among different and frequently conflicting ac- 
counting procedures. Accepted procedures for accounting for 
capital conversion completely destroy any comparability among 
the financial reports of corporations and in important degree 
make the process of valuation an exercise in futility. 

104 



ACCOUNTING FOR FIXED ASSETS 

Finally, the influence of essentially irrelevant factors such as 
income taxation and forms of financing is particularly evident in 
the case of fixed assets. That corporations pay income taxes and 
how they finance their productive resources are important facts 
which should be accounted for. They should not, however, be 
permitted to dictate the way in which resources held by the 
corporation and the uses of those resources are accounted for. 

Fixed-asset accounting illustrates clearly the extent to which 
accounting is still conceived of in terms of the monetary interest 
of stockholders. In large measure, it continues to ignore the role 
of the corporation as one of holding, in the interests of virtually 
all of us, the capacity to produce needed goods and services. 



105 



(^napter i/i 



ine 



COMPLEX BUSINESS 
COMBINATIONS 



Virtually all our large corporations are a collection of smaller 
organizations with varying degrees of individual identity and 
importance. Broadly speaking, these combinations fall into one 
of two categories which might be labeled integrated or con- 
glomerate. Corporate acquisitions of other enterprises used to be 
aimed almost entirely at the integration of the several elements 
of a production and distribution process under single manage- 
ment, or at essentially lateral expansion of the enterprise. United 
States Steel Corporation is an example of this sort of combina- 
tion. In recent years, there has been a steady increase in the 
creation of conglomerate corporations whose ralson d'etre has 
little to do with production and distribution. Businesses which 
have a record of operating losses are eagerly bought up because 
these losses can, for tax purposes, be offset against the taxable 
income of the purchaser. Purchase of another, albeit unrelated, 
business is often the most direct route to that contemporary 
desideratum— growth. Businesses are sometimes bought simply 
to obtain the services of a president or other official. These con- 
glomerate corporations have little beyond common ownership 
to bind them together. The Avco Corporation, for example, 
operates radio and television stations, makes agricultural ma- 
chinery, and engages in missile and space research. 

Whether the over-all combination is essentially integrated or 
a conglomerate of diverse activities, the smaller organizations 

106 



COMPLEX BUSINESS COMBINATIONS 

making it up may exist in one of two ways. They may be simply 
operational units based on geographical separation, product dif- 
ferences, company administrative philosophy, and the like. In 
other cases, the individual organizations exist as separate and dis- 
tinct legal entities. This may be so because of local company law 
or tax advantage. It may be so because inertia has kept from 
liquidation a previously acquired corporation. American Tele- 
phone and Telegraph Company is an example of a collection 
of separate corporate identities even though most of them do 
exactly the same thing and are collectively operated as a single 
business entity. General Motors Corporation, on the other hand, 
is (except for foreign subsidiaries) largely made up of nonincor- 
porated operating divisions, even though the divisions may be 
as different in a business sense as are the locomotives, automobiles, 
waffle irons, etc. which they manufacture and sell. 

Whatever the broad nature of the combination and however 
its several elements are organized, the existence of these complex 
corporations creates two largely contrary needs for information 
in appraising status and performance. There is a need for infor- 
mation about the over-all, essentially financial enterprise and a 
need for information about the individual business enterprises 
which make up the larger unit. Whatever the make-up of the 
corporation, the interest of the stockholder is essentially repre- 
sented by the net resources of the over-all enterprise. Informa- 
tion relevant to this interest is in some degree provided by the 
traditional process of consolidating financial statements. These 
are discussed in the latter part of the chapter. Information about 
the parts of the combination is in many ways the antithesis of 
consolidation and is in the interest of virtually all of the cor- 
poration's constituencies. Its provision is discussed in the fol- 
lowing pages. 

II 

For those who are not owners or top management but do 
have an interest in the affairs of the corporation, information 
about the over-all financial entity is important but information 

107 



mmmmmmmmrw 



Contemporary Corporate Accounting and the Public 

about the parts may be of equal importance. For example, the 
employee of a television or radio station of the Crosley Broad- 
casting Corporation, a wholly owned subsidiary of Avco Cor- 
poration, is no doubt far more concerned with the affairs of 
Crosley than he is with the New Idea Division of the corpora- 
tion which makes agricultural machinery or the Avco-Everett 
Research Laboratory which is engaged in missile and space re- 
search. Since his own personal stake presumably lies in the future 
of the broadcasting company, his primary need for information 
in evaluating that future is information about the broadcasting 
company, not about the plow factory nor about the financial 
combination of television station, plow factory, and space-re- 
search laboratory. 

Similarly, both customers and the public have an obvious 
need for information about, for example, the Electro-Motive 
Division of General Motors Corporation. This nonincorporated 
enterprise was largely responsible for developing the diesel- 
electric railroad locomotive and succeeded, in the ten years fol- 
lowing World War II, in selling seven out of every ten loco- 
motives in present use on American railroads. None outside of 
General Motors officials knows whether this division has been 
as successful financially as it has been in nearly monopolizing 
the railroad locomotive industry in the United States, yet for 
those who must evaluate the way corporations are meeting their 
widespread responsibilities this is vital information. 

In terms of accounting and reporting, dealing with such situ- 
ations involves some problems of accounting procedure, but 
essentially it is simply a matter of greater disclosure of relevant 
information. The accounting problem arises because the extent 
to which one division or subsidiary can be separated from other 
divisions or subsidiaries within the corporate complex is always 
problematical. In simple cases, the parent corporation provides 
some top-management service, including financing and perhaps 
legal services. In a more complex situation, divisions and even 
subsidiaries may share production facilities as well as manage- 
ment, legal, accounting, purchasing, advertising, selling, and 
other services. In the former case, it is relatively easy to isolate 

108 



COMPLEX BUSINESS COMBINATIONS 

the relevant resources and costs and revenues of the enterprise 
in question; in the latter case, any separation is bound to be 
difficult and arbitrary at best. 

Problems involved in accounting for the several parts of a 
greater whole are regularly faced in the preparation of data for 
internal management purposes. They are also generally en- 
countered where foreign subsidiaries are involved, because state- 
ments of some sort for operations within a country are required 
by company law and tax regulations in nearly all countries. Sub- 
ject to the qualifications set forth below, procedures followed 
in these cases are appropriate for the financial reporting of these 
complex corporations. 

It seems appropriate that the sales of all of a corporation's 
major products or services should be disclosed. Other types of 
information, such as costs, net income, assets, etc., appear to be 
required only when the parts of the complex are significantly 
different. To use General Motors as an illustration once again, 
the Electro-Motive Division and the Frigidaire Division are each 
sufficiently different from the several automobile divisions to 
warrant fairly complete disclosure of their affairs. They do, 
after all, operate in industries quite different from the auto- 
mobile industry, and there is no more reason to consider them 
in terms of the automobile industry than to think of the G.M. 
automobile divisions as a part of the home-appliance or loco- 
motive industries. (It is, in a sense, only a matter of chance and 
definition that General Motors Corporation produces refrigera- 
tors rather than "Frigidaire Corporation" producing automo- 
biles.) On the other hand, there seems no good reason for 
insisting on a separation of resources and expenses among the 
various automobile divisions of General Motors. It is presum- 
ably only a matter of administrative philosophy that inexpensive 
Pontiacs, for example, and expensive Chevrolets are manu* 
factured by different divisions. Any arguments for separate re- 
ports on these divisions would be equally relevant for separate 
reports on each of the various brands, models, etc. within these 
divisions. Such procedures generally applied would mean, for 
example, that the H. J. Heinz Company would have to publish 

109 



™™^"i™™" 



Contemporary Corporate Accounting and the Public 

fifty-seven financial reports. Such reports would serve no useful 
nonmanagement purpose and because of the virtual impossibility 
of separating common facilities the task would be rather like 
trying to unscramble an egg— the results would be virtually 
meaningless. 

Where significantly different businesses are held by common 
ownership, the possibility of presenting useful information about 
them is great simply because the businesses have so little in com- 
mon. Common production facilities are unlikely. (One cannot 
make plows in a TV studio.) Common distribution systems are 
often not feasible because the markets are so different. Common 
legal and financial services are generally quite possible, and, of 
course, over-all direction of a single top management is implicit. 
These services are often paid for by an assessment against the 
subsidiaries, a procedure quite common in the case of foreign 
subsidiaries. This procedure is a suitable basis for financial re- 
porting as long as the amount of the fees is disclosed. Some allo- 
cation of facilities might be required in some cases, but here 
again there should be no great problem in the use of such state- 
ments for evaluating the status and progress of the business if 
the basis of allocation is stated. 

Summary. When a large corporation operates basically sep- 
arate businesses, as is increasingly the case, there is a need on the 
part of all concerned for information relating to these essentially 
separate businesses. Whether the separate businesses are carried 
on by operating divisions or by legally distinct corporations is 
not, in this sense, important. Facts about significant parts of our 
economy should not be obscured by legal or operating pro- 
cedures. While separate reports on these businesses will include 
some arbitrary items, disclosure of the basis on which the items 
are included should insure objectivity. 
t 



In the preceding pages, the necessity for what might be 
called the fragmentation of the reports of large, conglomerate 
corporations has been discussed. It was suggested in the intro- 

110 



COMPLEX BUSINESS COMBINATIONS 

duction to this chapter that there is also a need for the combina- 
tion or consolidation of the financial statements of separate cor- 
porations which are, in a practical sense, all of a piece. The 
American Telephone and Telegraph Company may again be 
used as an illustration, for it is only because of historical acci- 
dent or state laws and regulations that there are several operating 
telephone companies within the Bell system. These operating 
telephone companies do the same thing and are, in fact, all a 
part of a national telephone system. To this extent, AT and T 
is a single business enterprise. (Some of its ancillary operations, 
such as its manufacturing subsidiary, Western Electric, are not 
necessarily a part of a telephone system.) 

In such cases, there are no financial statements or reports 
relating to the over-all business enterprise and thus no useful 
basis for financial appraisal and evaluation of the enterprise by 
an outsider. This is so because the over-all entity has no exist- 
ence in the legal sense, and accounting concerns itself with legal 
entities. In the traditional view, accounting is concerned with 
reporting on the sources and dispositions of property, and prop- 
erty must, by definition, belong to a person— real or legal. The 
business entity being discussed here does not have the legal status 
of person and thus has no property for which to account. The 
several parts of the entity own property; they have resources, 
capital, and income, and these are accounted for. The over-all 
financial entity does not. 

Unfortunately, the statements of the several legal parts of 
the entity are not likely to be of much assistance in appraisal 
and evaluation of the over-all groups of companies. Two basic 
reasons for this, discussed in more detail below, are: 

1. The resources, capital, and income of the holding company, 
shown on its financial statements, may be quite unrepresenta- 
tive of the resources, capital, and income of the economic 
entity as a whole. 

2. Analysis of the over-all entity through the separate state- 
ments of all of the organizations within the group is exceed- 
ingly complex, and perhaps impossible. In addition, the 
separate statements may, from the over-all point of view, 
be incorrect. 

Ill 



Contemporary Corporate Accounting and the Public 

Holding-company Statements 

In most situations, the equity securities of only the parent 
company are held outside the group of companies. In law, these 
securities represent ownership of the parent company alone. In- 
directly, of course, through the parent company's ownership, 
they represent ownership of the subsidiary companies. In many 
groups of companies, however, the parent company is simply 
a holding company with actual operations being carried on by 
the subsidiaries. In such instances the resources, capital, and in- 
come of the parent company may have little relationship to 
those of the whole group of companies. 

It is usual practice for a parent company to value its invest- 
ment in a subsidiary at historical monetary cost. Dividends re- 
ceived from the subsidiary are included in the parent company's 
income, but undistributed earnings of the subsidiary are not 
added to the value of the investment. Thus unless all of the 
earnings of the subsidiary are paid out as dividends, the net 
resources of the subsidiary owned by the parent will be larger 
than the investment in the subsidiary as shown on the books of 
the parent company. 

It is possible, of course, for the parent company to add to its 
investment account each year the undistributed earnings of the 
subsidiary company. A famous example of this practice has been 
the treatment by the Du Pont company of its investment in 
General Motors. (General Motors is not a subsidiary of Du 
Pont, but the latter has held approximately 22 per cent of Gen- 
eral Motors stock since that company's founding.) Each year 
Du Pont has adjusted its "Investment in General Motors" ac- 
count to equal its proportionate share in the net assets of Gen- 
eral Motors. The necessary write-up or write-down from the 
previous year's balance has been shown in the Du Pont income 
statement. 

This procedure has generally been frowned upon by ac- 
countants because it departs from the historical-cost basis for 
accounting and involves a so-called unrealized gain. Actually, 
the arguments made in other connections for stating current 

112 



COMPLEX BUSINESS COMBINATIONS 

values of all resources and the monetary equivalents of the capi- 
tal required to maintain the productive capacity of the corpora- 
tion are equally valid here. The current value of the net re- 
sources of the subsidiary (assuming its resources are adequately 
valued) are in all significant ways part of the value of the re- 
sources of the parent corporation. The form of ownership is 
different but its substance is that of direct ownership of the 
individual resources by the parent corporation. There seems no 
reason, other than the narrowly legalistic one, for not showing 
investment in subsidiary companies at its current value. 

Even if the foregoing were accepted procedure, however, 
the need for consolidated financial statements would not be 
eliminated. The parent or holding-company statement would 
show the current value of the subsidiary, but only in the aggre- 
gate. Important information about the resources and the sources 
of the capital of the over-all organization would be buried in 
a most uninformative "Investment in Subsidiary Company" ac- 
count. Nor would presentation of separate statements for the 
parent corporation and each subsidiary, in most cases, provide 
a workable solution to the problem of evaluating the enterprise 
as a whole. 

In the first place, if the enterprise consists of dozens of sepa- 
rate companies, which is not uncommon, or even of only five 
or six companies, it is practically impossible for even an expert 
to visualize the over-all situation. 

In the second place, the resources, capital, and income of the 
individual companies may be seriously overstated in terms of the 
total enterprise to the extent that transactions among the com- 
panies are included. A debt of one subsidiary company to an- 
other is in all ways a legitimate asset of the creditor company, 
but in terms of the total enterprise the debt has no more eco- 
nomic significance than would debts of one department to an- 
other in a single corporation. The same is true of purchases and 
sales among associated companies, which are appropriately a 
part of the purchases or sales of the companies themselves but 
are irrelevant in terms of the total enterprise. Without informa- 
tion about such intercompany transactions included in the re- 

113 



Contemporary Corporate Accounting and the Public 

sources, capital, and income of the individual companies of a 
group of companies, their individual statements cannot be relied 
upon to give a reasonable picture of the total enterprise. 

In order to overcome these several difficulties and to make it 
possible to present a statement of the financial and operating 
affairs of an economic entity, the device of consolidated financial 
statements has been developed. Such statements consolidate or 
put together the statements of the separate companies and ap- 
proximate the financial statements which would exist if the entire 
enterprise were operated under a single corporate structure. 

Basically, the consolidation of financial statements involves 
canceling out or eliminating transactions between the companies 
whose statements are being consolidated. An illustration may be 
based on a sale, for credit, by Company A to Company B. This 
transaction involves a sale and an account receivable for A, a 
purchase and an account payable for B. In consolidation of the 
statements of A and B the receivable of A and the payable of 
B would be canceled out on the grounds that in terms of the 
economic entity the obligation is of itself and to itself. The 
revenue from the sale recorded by A and the cost of the sale 
recorded by B would also be eliminated since for the economic 
entity the sale is, in effect, by itself to itself. 

There may be many difficult operational problems involved 
in consolidating financial statements, but for the most part these 
do not affect the substance and meaning of the results. More im- 
portant is the subjective question of when consolidation of 
financial statements should be undertaken. This is considered in 
the following section. 

Conditions for Consolidation 

It has already been said that the purpose of consolidation 
statements is to portray the financial results of the operations 
of an economic entity not represented by a corresponding legal 
entity. The idea of an economic entity implies control of its 
assets, including freedom to shift assets within the enterprise. 
The idea also implies some degree of similarity among the several 
parts of the entity. Because of these implications, a number of 

114 



COMPLEX BUSINESS COMBINATIONS 

considerations are involved both in a decision to present con- 
solidated financial statements and in the interpretation of such 
statements. 

Ownership. Control of assets is basically a function of 
ownership and thus the extent of ownership of the equity of 
subsidiary companies becomes a governing factor in consolida- 
tions. Probably the vast majority of subsidiary companies are 
entirely owned by the parent organization. There are, however, 
many partially owned subsidiaries, usually those which have 
been purchased as going concerns. Thus it becomes necessary 
to consider the extent of ownership of a subsidiary, which should 
be prerequisite to including it in a consolidation. 

Many companies follow the rule of consolidating only those 
subsidiaries which are 100 per cent owned. Such a rule leaves 
no doubt about the question of control, though it does not 
guarantee freedom to shift assets within the enterprise. It also 
has the virtue of simplicity because it eliminates the necessity for 
indicating the minority interest which is involved when partially 
owned subsidiaries are consolidated. (See below.) 

On the other hand, this rule may not result in a presentation 
of the financial results of operations of a de facto economic 
entity, because control of assets may exist even when ownership 
is not complete. While a minority shareholder has some legal 
"rights," these are generally not strong enough to prevent an 
action of the majority. For this reason, some companies follow 
the rule of consolidating the assets, liabilities, and profits of all 
subsidiary companies of which they own in excess of 50 per 
cent. Between 50 per cent ownership and complete ownership 
there is, of course, a great variety of possible ownership levels 
which may be considered as representing effective control. 1 



""When partially owned subsidiaries are included in consolidated statements, 
some modification of the statements is required. It is usual practice to in- 
clude all of the resources of all of the corporations in the consolidation but to 
indicate that they are not entirely owned by the consolidated group by indicat- 
ing the amount of the minority interest. (In general this is equal to the par 
or stated value of the stock held plus a pro rata share of retained earnings.) 
This amount is neither a liability of the consolidation nor a part of its equity. 
It is usually labeled "Minority Interest in Subsidiary Company" and listed 
after the consolidated liabilities and before consolidated equity. 

115 



Contemporary Corporate Accounting and the Public 

Similarity. In many instances, one company may have com- 
plete ownership of another company without there being a sound 
basis for consolidation of financial statements. This would be 
the case in situations where the owned and owning companies 
are engaged in totally different types of business and thus the 
economic entity which consolidated statements are intended to 
represent does not exist. For example, a bank, as a result of the 
default of a debtor, might find itself the sole owner of a spaghetti 
factory. Few would argue that banking and spaghetti making 
form an economic entity. Because of this lack of similarity, the 
American Telephone and Telegraph Company does not include 
in the consolidated statements of the group of operating tele- 
phone companies the accounts of Western Electric Company, 
its manufacturing subsidiary, which is almost entirely owned by 
American Telephone. For similar reasons, General Motors con- 
solidates the accounts of its many manufacturing subsidiaries but 
excludes the wholly owned General Motors Acceptance Corpo- 
ration, which is a finance company. 

In this area, as in the case of ownership, decisions are in- 
evitably subjective. There can be no hard and fast rules as to 
what constitutes an economic entity. General Motors considers 
the manufacture of automobiles, railway locomotives, and house- 
hold appliances as an economic entity. Some other company 
might consider waffle irons and Cadillacs quite unrelated. 

Foreign Subsidiaries. The existence of foreign subsidiaries 
poses some particular problems in terms of consolidated financial 
statements. Ownership of a foreign subsidiary may be complete 
and it may be in exactly the same business as the home-country 
parent yet, because of exchange controls, freedom to shift assets 
within the entity may not exist. Some countries may have ac- 
counting and fiscal regulations which make the statements of 
a company in that country quite noncomparable with those in 
other countries. Consolidation also creates problems of currency 
conversion, since consolidated statements can have meaning only 
when stated in a single currency. If the value of one currency 
fluctuates in terms of the other, should one use values at state- 
ment date, average rate, year-end rate, etc.? More broadly, does 

116 



COMPLEX BUSINESS COMBINATIONS 

a consolidated statement of assets based on hard currencies with 
assets based on currencies subject to extreme inflation have any 
practical significance? Once again, answers to these questions 
must be highly subjective. 

The objective in consolidating financial statements is to go 
beyond essentially artificial legal barriers and try to present fairly 
the financial status of an economic entity. In order to do this 
one must have some criteria by which the existence of an eco- 
nomic entity can be established. Such criteria are embodied in 
the questions just discussed: degree of ownership, extent of 
control over resources, nature of businesses, etc. Generally speak- 
ing, there can be no hard and fast rules about these matters and 
each case must be decided on its own merits. Furthermore, these 
questions become less critical if consolidation is not thought of 
in all-or-nothing terms, if the need to disclose significant in- 
formation is not lost sight of in concern for the process of 
consolidation. It may be stated again that consolidation is a use- 
ful way of indicating the interest of stockholders. In the case 
of a group of companies representing a basically unified pro- 
duction and distribution process, consolidated statements may 
reveal other important information as well. In the case of con- 
glomerate combinations consolidated statements obscure more 
than they reveal— except about the stockholder interest. Thus if 
one accepts the necessity for disclosing all relevant information 
about the parts of the whole as well as about the consolidated 
whole, the several criteria for consolidation become of less im- 
portance. 

IV 

One further aspect of consolidated financial statements arises 
because the price paid by one corporation when purchasing 
another is rarely equal to the accounting value of the purchased 
company. (For the sake of simplicity, the situation will be dis- 
cussed where price paid exceeds the accounting value. This seems 
the more usual situation, though the reverse can be and some- 
times is true. The basic problem is the same in either case.) 

117 



^^mMHOTWVBMMHHHI^^HHMPPVV? 



Contemporary Corporate Accounting and the Public 

Broadly speaking, this situation results from a combination of 
two facts: recorded assets of the purchased company are under- 
valued or some of its assets are not recorded at all. Put another 
way, the price paid for a going business is presumably related 
to the current market value of that business which is, in turn, 
a function of the present value of the future earnings of its 
resources. Such values are almost never reflected in a corpora- 
tion's accounts. 

As far as the purchasing company is concerned, the value of 
its investment is, at the time of purchase, the amount paid for 
the other business. (The cost is obvious if the purchase price 
is paid in cash. If, as is frequently the case, it is paid for in the 
stock of the purchasing company, some complications may arise. 
However, as long as the stock of the purchasing company has 
a recognized market value— and in the case of the large corpora- 
tions with which we are concerned, this will virtually always be 
so— this market value obviously represents the price paid.) Thus, 
the equity in the purchased company, based on the price paid 
for its shares, will appear in the accounts and statements of the 
purchasing company at a higher amount than the amount of the 
equity as shown in the accounts and statements of the purchased 
company. This discrepancy is not apparent until one consoli- 
dates the statements of the two corporations, but then it will be 
impossible to eliminate the entire investment of the parent cor- 
poration against the equity of the subsidiary. 

These are recognized accounting procedures for dealing with 
this excess of investment over book value of a subsidiary 
company: 

1. To carry the amount on the consolidated statement as a 
so-called intangible asset under some such heading as "Good 
Will Arising from Consolidation." 

2. To allocate the amount to various individual assets. 

3. To write off the amount against consolidated retained earn- 
ings. 

In my view, the latter has no validity. The purchase of the 
subsidiary by another surely establishes the value of its aggregate 

118 



COMPLEX BUSINESS COMBINATIONS 

resources and it is contrary to the basic objective of disclosure 
of all resources to write off the amount. If the excess arises 
because the subsidiary's listed assets are undervalued, the amount 
should be added to the value of these assets and thus appear in 
the consolidated statement. If the excess arises because some of 
the subsidiary's assets (probably intangible assets) are not listed 
at all, these resources should be described and listed. (This 
matter is discussed in Chapter Eleven.) 

If accounting is based on current values rather than historical 
monetary values, this problem will arise must less frequently. 
In such cases their book value would be approximately equal 
to current value which means book value would be close to 
the purchase price. (It is unlikely the two would be exactly the 
same, because the net resources of a subsidiary would probably 
have a different value as a part of a combined enterprise.) The 
important thing, however, is that the value of resources is 
established at the time of the purchase of the subsidiary and 
if recorded values are different the latter should be changed. 
The difference should not be written off. The value established 
by purchase is not, of course, good for all time, and should be 
changed as the value of the resources involved changes. 



Accounting for Mergers 

The foregoing discussion was related to the consolidation of 
the statements of legally separate companies which are in other 
than legal respects parts of a single business enterprise. In many 
situations it will be expedient to do away with the legal distinc- 
tions too, and merge the purchased company into the purchas- 
ing company. This would always happen when a business's 
assets, rather than its stock, were purchased. 

In the case of a merger, the accounting and reporting prob- 
lems, considered from the point of view of the interested out- 
sider, are little different from those already discussed. It is 
important that necessary information about a significant business 
enterprise not be lost. If the purchased company and its affairs 

119 



Contemporary Corporate Accounting and the Public 

are important to workers, to customers, to suppliers, to the 
public generally, the fact that it no longer has an independent 
legal identity should not be allowed to stand in the way of con- 
tinued availability of information about its status and progress. 
The valuation of the acquired assets involves the same prob- 
lems discussed elsewhere. The important thing here is that the 
price paid for the net resources of the company presumably 
establishes the present value of the net resources at the time of 
purchase, and therefore that value should be used in accounts 
and reports. 

Pooling of Interests 

In recent years, accounting has given acceptance to a pro- 
cedure which arises from the proposition that many business 
combinations are not, in fact, the sale of one business to another 
but are simply a pooling of interests by the owners of the two 
enterprises. The distinction between a purchase and a pooling 
of interests is spelled out in substantial detail in Accounting Re- 
search Bulletin No. 48 of the American Institute of CPA's. In 
essence, a pooling of interests is recognized when the ownership 
interest in the assets of the several corporations is not changed 
by the combination of the businesses. The maintenance of sub- 
stantially the same proportionate interest and voting rights is 
required. The continuation of all the elements of the business and 
the continuation of the control of the previous managements 
are similarly required. Put in the opposite way, there would be 
a purchase rather than pooling of interest when the ownership 
interests or proportionate control of any of the owners is 
eliminated or substantially changed; if a significant part of the 
business is abandoned or sold; if any of the control or influence 
of any of the previous management is eliminated. 

The essential accounting distinction involved in a pooling of 
interests is that no new basis for accountability arises whether 
the individual companies retain their identity, are merged into 
one of the companies, or all disappear into an entirely new com- 
pany. In a merger, the net assets of the purchased company 
would be added to those of the purchasing company. The capital 

120 



COMPLEX BUSINESS COMBINATIONS 

and retained earnings of the purchased company would dis- 
appear. If the net resources of the purchased company were 
acquired at greater or less than their book values, their value 
would presumably be adjusted to the new values. In a pooling of 
interests neither of these would happen. The assets, liabilities, 
capital, and retained earnings of the pooled companies would be 
taken at their book values and simply added together. In the 
case of merger the equity of the surviving company would be 
equal to the equity of the purchasing company, plus or minus 
any change in the value of the assets of the purchased company. 
In a pooling of interests, the equity of the surviving company 
would be equal to the total equity of the pooled companies 
without any change in the value of combined resources. 

When companies which have been pooled retain their corpo- 
rate identities (for the same reasons that any subsidiary com- 
panies are kept as legal entities) it will usually be desirable to 
publish combined or, in effect, consolidated financial statements. 
The differences between such statements and those described 
earlier would be that the equities of the pooled companies would 
make up the combined equities and there would be no excess of 
investment over assets or excess of assets over investment. 

The principal practical reason for following the pooling-of- 
interests approach, rather than the traditional merger, is that 
the retained earnings, and therefore the dividend-paying capacity 
of the combined enterprise, are not reduced. In a merger, the 
retained earnings of the merged company disappear, and thus 
the dividends that may legally be paid are reduced by the amount 
of the retained earnings. If the transaction is, in fact, a pooling 
of interests, there seems no good reason why it should not be 
accounted for in this way. A clearer statement of facts is given 
and no accounting artificialities are introduced. 

On the other hand, the pooling-of-interests approach may 
mean a continuation of unrealistic accounting valuations by not 
making it necessary to face up to the actual existence of more 
realistic values. This is not, it should be added, a fault of the 
pooling-of-interest approach per se. If meaningless accounting 
values exist, they exist because of the accounting procedures 

121 



Contemporary Corporate Accounting and the Public 

followed by the individual companies. However, in the case of 
a merger or in the consolidation of financial statements of cor- 
porate subsidiaries, inadequate accounting valuations of the re- 
sources of at least one of the companies must be faced up to. 

VI 

Increasingly, the business of the nation is carried on by large, 
conglomerate corporations which have, in many cases, gathered 
a wide variety of businesses under a single financial roof. In 
other cases, an essentially integrated business may be fragmented 
among a number of legally separate corporations. These facts 
create two problems in terms of the evaluation of large corpora- 
tions by those to whom the corporations have responsibility. In 
the first place, information about broadly important and es- 
sentially distinct enterprises must not be obscured by the fact 
of common ownership. Common ownership is relevant only to 
the ownership interest and, in part, to the management interest. 
For some of the other interests it is most irrelevant. 

In the second place, the existence of separate legal entities 
must not result in sight being lost of de -facto business enterprise. 
It is particularly important for the ownership interest that the 
business and ownership entity be reported upon. 

Thus, the existence of large and sometimes conglomerate 
enterprises calls for both combination and fragmentation in ac- 
counting reports. Each of these will reveal facts and relationships 
essential to the evaluation of the way in which corporations are 
meeting their widespread responsibilities. 



122 



(chapter Jen 

COMPENSATION 



Two accoutrements of the contemporary corporation are 
the pension plan and the stock option. They are obviously re- 
sponses to high rates of personal-income taxation for both pro- 
vide the employee with a certain amount of low-tax or tax-free 
income. They are also, however, manifestations of the scope of 
present-day corporate responsibilities for they are based on some 
idea of responsibility for the relative welfare of employees- 
including management. Since both these procedures involve a 
type of compensation in the future for services rendered in the 
past, at present, and in the future, they are vivid illustrations of 
the inadequacy of the short-run, "as-of-now" view of the 
corporation. Implicit in both is the idea that the corporation will 
continue to exist far into an indefinite future. 

From the point of view of accounting, these methods of 
compensation raise two questions. In the first place, they empha- 
size the need for basing accounting principles and procedures on 
more than the ownership interest. Owners obviously have an 
interest in compensation, because it directly affects their own po- 
tential share of corporate resources. Employees have a manifest 
interest in compensation and especially in the provisions made 
for promised future compensation. In the case of both pensions 
and stock options, but especially the latter, there are some im- 
portant questions of the broad public interest. Consequently, 
accounting for these procedures must be oriented to the re- 
quirements of all the constituencies of the corporation. 

The second accounting question is indefiniteness. At the 

123 



Contemporary Corporate Accounting and the Public 

time pension and stock-option arrangements are entered into 
there is no definite and readily ascertainable cost, nor is their 
duration definite or even reasonably certain. Thus two of the 
main props of traditional accounting procedure are missing. 
Their absence creates no unsolvable problems but it does re- 
quire a willingness to accept accounting methods which are 
different and which yield only uncertain results. The first part 
of this chapter is devoted to pension plans, and the second to 
stock options. It should be borne in mind that both of these are 
discussed here only in terms of accounting. Many economic, 
social, even political problems associated with these forms of 
compensation of corporate employees and managers are beyond 
the scope of this work. 

II 
ACCOUNTING FOR PENSION PLANS 

There is probably no better illustration of the present-day 
scope of corporate responsibilities than the rapid spread of 
pensions for retired employees, largely paid for by employers. 
This is not to say that the initiation of pension plans is solely a 
response by corporation managers to moral or compassionate 
considerations (or to selfish ones for that matter, since managers 
themselves are liberally pensioned). Undoubtedly the combina- 
tion of high profits and favorable tax treatment of contributions 
to pension funds has been a factor in their growth. Certainly 
there is a competitive aspect to pensions, too, for they are an 
important factor in recruiting and retaining personnel. Probably 
the greatest pressure has come from general public acceptance 
of the idea of pensions, which has been a response, in part at 
least, to the ever-increasing proportion of aged in the popula- 
tion. However mixed the motives, the adoption of pension plans 
is a concrete manifestation of responsibility to . employees— in- 
cluding the members of the management group. 

The existence of pension plans also implies the long-run, 
on-going view of the corporation. While no pension plan is 
set up in perpetuity, one is by its very nature inconsistent with 

124 



COMPENSATION 

the short-run view of the corporation since it creates a de facto 
obligation of generally indeterminate amount which stretches 
far into an indeterminate future. Pension plans clearly assume 
the pensioning corporation will exist for a very long time. 

In the following paragraphs the basic characteristics of con- 
temporary pension plans are briefly described. The purpose of 
these paragraphs is simply to sketch those characteristics which 
influence accounting and thus they are in no sense concerned 
with the multitude of variations found in pension plans nor with 
the many financial, economic, and social ramifications of these 
plans. 1 

Basic Characteristics 

Duration. Most corporation pension plans are provided for 
in employment contracts or agreements— individual or collective 
—and the contract or agreement is for a limited time, subject to 
termination and modification at the expiration of such a period 
of time by management of the corporation. It is quite under- 
standable that the contractual or understood basis for such plans 
would include provision for termination and modification on 
the grounds of ordinary prudence if nothing else. On the other 
hand, it seems eminently reasonable to accept as highly probable 
the relative permanence of pension plans. Internal Revenue 
Service regulations governing the deductibility of employer 
contributions to pension funds have tended to make the plans, 
in fact, permanent. 2 Perhaps of even greater importance is the 
simple fact that the idea of a pension has become such an im- 
portant part of our socioeconomic structure. Pension plans have 
come to be considered the right of the employee rather than the 
option of the employer to such a degree that the relative perma- 
nence of pension plans seems far more certain than does arbitrary 
abandonment by management. 






Excellent coverage of all aspects of pension plans is found in Don M. 
McGill (ed.), Pensions and Trends (published for the S. S. Huebner 
Foundation for Insurance Education) (Homewood, 111.: Richard D. Irwin, 
Inc., 1955). 

*Ibid., p. 76. 

125 



Contemporary Corporate Accounting and the Public 

Benefits. Benefits under most contemporary pension plans 
fall into one of two broad categories. The first of these is the 
so-called money-purchase plan under which the corporation's 
annual payments into the fund are fixed and the amount of the 
benefit, therefore, is variable depending on the future earnings 
of the fund, length of service of the employee, etc. The second 
category involves a definite benefit which is usually, though not 
necessarily, related to the employee's earnings. Definite benefits 
of necessity make payments into the fund variable for the same 
reasons that make benefits variable under the money-purchase 
scheme. Most industrial pension plans are of the definite-benefit 
type. 

Past Service. Pension plans are almost invariably retroactive 
in the sense that benefits are based on the total service of the 
employee, not just his service after adoption of the plan. This 
means, of course, that a substantial unpaid obligation for these 
past service benefits comes into being at the moment the plan 
becomes effective. Furthermore, the problem of past service 
benefits may be a recurring one for any time the benefits or 
coverage of a pension plan are increased a new obligation re- 
sulting from past service arises. Paying for past service benefits 
is an area of major difference among pension plans, and ac- 
counting for them is quite frequently most unsatisfactory. 

Funding. A number of different methods are in current 
use for providing for the costs of pension plans. These will be 
considered presently, but before doing so it is necessary to 
understand that the precise amount of the obligation for pension 
benefits can never be known in advance. Some assumption 
must be made about both future market values and earnings 
rates of pension-fund investments. Changes in either of these 
will, of course, affect the amount in the fund at any time. A 
decrease in the number of employees or a change in the rate 
of turnover of employees will upset the calculations of amounts 
required to meet future benefit payments. These matters can 
be and are taken into account by actuaries when setting up a 
plan, but a degree of uncertainty remains about the exact 
amount of the liability arising from a pension plan. 

126 



COMPENSATION 

The soundest method of providing for the cost of future 
pension benefits involves annual payments into a fund which 
are equal to the cost of current service benefits plus some re- 
duction or amortization of incurred past service benefits. Both 
of these can be determined actuarially, although selecting the 
rate of payment of the liability for past service benefits is in- 
evitably somewhat subjective. There is obviously a conflict 
between the desirability of complete solvency for the fund 
which would require immediate payment of the full past service 
liability and the drain on the company's resources which prob- 
ably requires spreading the annual payments over a period as 
long as possible while still reasonably safe. In the case of a single 
employee it is only necessary that past service benefits be paid 
in before he retires. When many employees are involved, the 
rate of payment is perforce based on an average of times to re- 
tirement and therefore somewhat uncertain. Ten-year and 
thirty-year periods are the most common rates of payment, al- 
though many other rates are in use. 3 

To qualify for favorable treatment under income-tax regu- 
lations, a pension plan must, as a minimum, fund all current 
costs, which are defined as the cost of current service costs plus 
the assumed interest on the present value or unfunded portion 
of past service costs. In effect, this means that the cost of past 
service benefits is not being funded. No doubt because of this 
minimum requirement of the Treasury Department, many pen- 
sions are funded in this way. (Treasury regulations also permit 
a maximum deduction for tax purposes of 10 per cent per year 
for costs of past service benefits. This no doubt explains the 
popularity of the ten-year amortization period referred to in 
the previous paragraph.) 

A less desirable procedure from the point of view of sound- 
ness is so-called terminal funding. Under this procedure no 
funding is done prior to the employee's retirement. At that 
time, a single payment is made in an amount sufficient, on an 



3 Leonard Lorenson, "Pension Costs in Selected Financial Statements, 
Journal of Accountancy, Vol. 113, No. 3 (March 1962), p. 61. 

127 



Contemporary Corporate Accounting and the Public 

actuarial basis, to meet the future benefit payments to the re- 
tired employee. 

Finally, some pension plans are operated without any fund- 
ing at all. They are on a "pay-as-you-go" basis which means 
that benefits are paid directly to retired employees out of the 
company's treasury at the time the benefits are due. Obviously, 
such plans are least desirable from the employee's point of view 
since they leave him completely dependent for his pension on 
the company's financial state at that future time when he retires. 

The Accounting Problems 

The basic accounting problem is clear. Should corporate 
financial reports show the full extent of the highly probable 
future liability for pension benefits whether corporation man- 
agement has funded the liability or not? Should the best possible 
estimate of cost— past, present and future— be included in the 
measurements of annual income? Or to put the question more 
bluntly, should accountants follow a procedure which best 
serves the needs of those who are evaluating corporate status 
and prospects, even if in doing so they depart from accounting 
for what management has done? 

From the point of view of the pensioner-to-be there seems 
no disputing that a full funding of all benefits (past service and 
current service to date) is the most satisfactory procedure. Such 
a fund is the best measure of the present value of a future lia- 
bility and consequently seems the required basis for accounting 
for the pension plan. 

Companies frequently give two grounds for not fully fund- 
ing pension plans and therefore, by implication, for not account- 
ing for the full liability. The first of these arguments stresses 
the absence of any legal obligation to continue the plan, which 
means that the corporation's legal liability is only for those 
amounts which have vested in the employees at any time. The 
second of these arguments is based on the premise that the 
entire fund will never be claimed at one time. That is, benefits 
due to one employee can be met from contributions on behalf 
of an employee not to be pensioned for some time. In a sense 

128 



COMPENSATION 

this is robbing Peter to pay Paul, although given a more-or-less 
even distribution of annual retirements, in terms of both num- 
bers of employees and amounts of their pensions, such a policy 
is not necessarily unsound financially. 

The response to the first of these arguments has already 
been given. The overwhelming social acceptance and approval 
of pension plans almost surely represent a de facto constraint 
on management's freedom to curtail a pension plan— legalities 
notwithstanding. That the full amount of the liability will never 
be claimed at one time can be accepted as a sufficiently sound 
and prudent basis for financial management. It is not, however, 
a basis for stating the actual liability of the corporation, and 
statement of the liability and the related cost is the function of 
accounting. Incidentally it is interesting to observe the mutual 
incompatibility of these two arguments. Paying benefits to one 
person out of contributions in respect to another is obviously 
based on the assumption of indefinite continuation of the plan. 
It would not be possible if a plan were discontinued. 

Thus, sound accounting for pension plans should show the 
actuarially determined amount of the present liability under 
pension plans. That is, all benefits incurred to date including all 
past service benefits should be shown in financial statements. 
(Because of the various factors mentioned earler, which can 
affect these actuarial calculations, they should be revised regu- 
larly.) Furthermore, the financial reports should state the 
amount funded to date. The funds will, of course, be included in 
the amount of the corporation's resources unless they have been 
deposited with a trustee or used to purchase future benefits 
from an insurance company or similar institution. 

As far as income determination is concerned, the annual 
increments in the future liability for pension benefits is clearly 
an appropriate deduction from realized gross income. Pension 
plans are obviously a cost of the business. The proper timing 
of deductions for past service benefits raises something of a 
problem because in most cases the amount of the cost involved 
will be greater than can be absorbed by realized gross income 
in the first year after adoption of the plan. Most accountants 

129 



Contemporary Corporate Accounting and the Public 

argue that pension costs are costs of future years after adoption 
of the plan and therefore maintain that all costs should be de- 
ducted in future periods and conversely none of the costs should 
be deducted from retained earnings at the time of the adoption 
of the plan. This is not an unreasonable approach from the point 
of view of income determination, but it is unreasonable in terms 
of valuation of resources and claims against them. Once a pen- 
sion plan is instituted the corporation has a future liability on 
account of past service. This claim of employees has legal 
precedence over the claims of stockholders. Consequently, the 
claim should be shown and should, if necessary, be deducted 
from the claim of stockholders represented by retained earnings. 
Ultimately, of course, there will be no difference between this 
procedure and the procedure of amortizing past service costs 
over a period of years. At the conclusion of the amortization 
period, the amount of retained earnings, all else being the same, 
will be identical in either case. In the one case, an obligation of 
the corporation is always shown; in the other case it is not. 

Current Accounting Practice. The AICPA Accounting 
Procedure Committee has recommended, in Bulletin #47, that 
pension-plan accounting should include "... costs based on cur- 
rent and future services . . . systematically accrued during the 
expected period of active service of the covered employees, 
generally on the basis of actuarial calculations." Furthermore, 
the committee has recommended that "costs based on past 
services should be charged off over some reasonable period. . . ." 4 
In other words, accounting for pension plans should not be 
governed by the actual funding (or nonfunding) procedures of 
the corporation. The committee has not, of course, accepted 
the view stated here that the full liability for past service bene- 
fits should be recognized at once. 

With typical caution, however, the committee recognized 
that at the time (1956) its recommendations were somewhat 
in advance of general practice and so sanctioned pro tempore 



4 American Institute of Certified Public Accountants, Accounting Research 
Bulletin 41 (New York, 1956) para. 5. 

130 



COMPENSATION 

a minimum standard of "accruals which equal present worth, 
actuarially calculated, of pension commitments to employees 
to the extent that pension rights have vested in the employees." 5 
It is an interesting illustration of the extreme deliberation with 
which accounting principles evolve that according to a recent 
study, "a significant number of companies" are still meeting the 
pro tempore minimum standard and not accounting for full 
actuarial costs. 6 

Summary. There seems little doubt that private corporation 
pension plans are here to stay. There is also no doubt that they 
represent future claims of very substantial proportions on the 
resources of our corporations. A proper evaluation of corporate 
status and affairs cannot be made without full information about 
pension plans and such information should include the full 
amount of the present and future liability under the pension 
plan as well as the amount of this liability which has actually 
been met by payments into a fund. 



STOCK OPTIONS 

To some, stock options are one of the main sources of 
strength and growth in the American economy. Henry Ford II, 
businessman, believes they are in the public interest because they 
"foster both the most efficient use and the most economical 
allocation of one of our scarcest and most precious natural re- 
sources—management." 7 To others, stock options are discrimina- 
tory and immoral devices which strike at the foundations of 
our society. J. A. Livingston, financial editor, states that, "Exec- 
utives have become an overprivileged class in a democratic 
society. Their power to overpay themselves without legal sanc- 
tion, could, if unchecked, erode the very structure on which 



5 Ibid., para. 7. 
€ Lorenson, loc. cit. 

7 Henry Ford II, "Stock Options Are in the Public Interest," Harvard Busi- 
ness Review, Vol. 39, No. 4 (July-August, 1961), p. 51. 

131 



Contemporary Corporate Accounting and the Public 

they and their corporations depend for survival. 8 A somewhat 
more temperate critic, Peter Drucker, suggests that stock op- 
tions "really provide a businessman's gain without a business- 
man's risk, or offer extra pay only for doing one's best. These 
are hardly compatible with the professional role of the exec- 
utive." 9 

These views are representative of the wide range of opinions 
about stock options. Discussion of these opinions and others is 
not relevant to my purpose here although I must observe in 
passing that my views are much closer to those of Messrs. 
Livingston and Drucker than to those of Mr. Ford. What is 
relevant here is that such extreme controversy creates a certain 
need for complete and detailed accounting for stock options. 
And if this is not sufficient grounds for absolute exposure to all 
who are concerned with corporate affairs, the limitation of 
stock options to a few top managers (who in a practical sense 
grant them to themselves) certainly is. 

Characteristics of Stock Options 

Whether it is concluded that stock options are a source of 
good or of evil, there is no apparent dispute over the fact they 
accomplish that good or evil through being legalized evasion 
of high personal-income tax rates. Thus the discussion which 
follows is confined to the so-called restricted stock option which 
qualifies for special tax treatment. Without this treatment, stock 
options would be a most insignificant matter. 

The essential characteristics of restricted options are, in 
brief, the following: the price at which the option may be 
exercised must be at least 95 per cent of the fair market value 
of the stock at the time the option is granted. The stock must 
be held for two years after the option was exercised. In other 
words, to qualify for special tax treatment, stock may be pur- 
chased eighteen months after granting of the option and sold 



8 J. A. Livingston, The American Stockholder (New York: J. B. Lippincott, 
1958), p. 222. 

9 Peter F. Drucker, "Big Business and the National Purpose," Harvard Busi- 
ness Review, Vol. 40, No. 2, (March-April, 1962), p. 58. 

132 



COMPENSATION 

six months after purchase or two years after the option was 
received. If these conditions are met, any gain over the option 
price is tax free to the holder as long as the stock is held— even 
by his estate after the holder dies. If the stock is sold, the gain 
is taxed as a capital gain rather than as ordinary income. If the 
option price is between 85 per cent and 95 per cent of fair 
market value on the date the option was granted, a somewhat 
more complicated and less favorable set of rules applies. If the 
recipient of the option holds more than 10 per cent of the 
corporation's stock, there are still further qualifications. The 
"95 per cent option," however, is the most common and is 
assumed in the discussions which follow. The foregoing describes 
only the requirements for special tax treatment; it does not 
necessarily describe actual option plans which may, for ex- 
ample, require that the option not be exercised for a period of 
three or more years and generally limit the period during which 
the option is outstanding. 

Definition of Cost 

Most discussions of accounting for stock options go into 
the question of whether or not they represent compensation of 
the executives who receive them. There seems no reason to 
doubt that they do. In his discussion of stock options Henry 
Ford II uses such phrases as "to provide incentives for them 
[managers] to work most effectively and productively," and 
"reward commensurately with their contribution." These are 
obvious descriptions of compensation. Whether they are precise 
substitutes for more conventional compensation is another ques- 
tion. However, does it really make any great difference, in 
terms of proper accounting, whether stock options are compen- 
sation either for past or future service, an investment in execu- 
tive talent, or little more than a way of recognizing that the 
optionee is a pleasant fellow? The important accounting func- 
tion is the measurement of the cost to the corporation of grant- 
ing the option and this measurement should not be influenced 
by reasons for incurring the cost. The amount of the cost, on 
the other hand, is of great importance in evaluating the wisdom 

133 



Contemporary Corporate Accounting and the Public 

or propriety of incurring it. In the days when the ceremonial 
gold watch was the symbol of corporate eminence, evaluation 
was not important because cost was insignificant. Stock options 
may involve millions. 

The difficulty with stock options is that their cost must be 
imputed, and accountants in particular have long been reluctant 
to have anything to do with imputed costs. In the conventional 
monetary sense, no cost is incurred because rather than spend- 
ing money the corporation treasury actually receives money 
when the employee purchases stock under an option. The cost 
of options must be imputed in terms of the opportunities the 
corporation loses by entering into and completing the option 
arrangement. (This, of course, has no necessary connection with 
what the corporation gains by the stock option. Mr. Ford and 
Mr. Drucker, for example, would view this matter quite 
differently.) 

When a corporation sells stock to an executive under an 
option plan it loses the opportunity to sell the stock to someone 
else at a higher price. (An executive holding an option is not 
likely to exercise it if current market price is less than option 
price. In fact, during the stock market decline of 1957-1958 
some corporations canceled options outstanding and reissued 
them at a price below the new and lower level of market prices. 
As Erwin Griswold has suggested, this makes options truly a 
"heads-I-win, tails-you-lose" proposition for executives who 
hold them. 10 ) The cost of the option to the issuing corporation 
represented by this lost opportunity is the difference between 
the market price of the stock and the option price when the 
stock is sold. 

Some writers have also included as a part of option cost the 
tax deductions which would result from equivalent salary pay- 
ment. Under tax laws, no cost to the corporation is recognized 
in connection with stock options. Salary payments, of course, 
are deductible for tax purposes and the corporation's income- 



10 Erwin N. Griswold, "Are Stock Options Getting Out of Hand?" Harvard 
Business Review, Vol. 38, No. 6 (November-December, 1960), pp. 52-53. 

134 



COMPENSATION 

tax obligation (all else being equal) is reduced (at present rates) 
by 52 cents for every dollar being paid in salary. Therefore it 
might be concluded that 52 per cent of the value of the lost 
opportunity associated with the option is an additional cost of 
the option. 

There are two difficulties with this approach. In the first 
place, if one is to think in terms of equivalent benefit to the 
executive, one must think of after-tax benefit since the monetary 
attractiveness of the option is a function of the tax concession 
involved. Because of different tax treatment, equivalent salary 
payment would not yield the same after-tax income to the exec- 
utive. Therefore, the alternative salary payment required might 
be substantially different from the opportunity costs of the 
option. A recent study 11 suggests that in most cases the salary 
equivalent which would yield an after-tax break-even with an 
option benefit to the employee would have to be substantially 
larger; but somewhat surprisingly, it actually would be lower 
in a significant number of cases. 

The second difficulty with this approach lies in the assump- 
tion that a salary payment is the only alternative to a stock 
option. Some form of deferred compensation (discussed below) 
might be a suitable alternative. Perhaps the executive would 
have demanded a higher after-tax benefit to compensate for the 
loss of status resulting from being without options. Perhaps he 
would have settled for lower after-tax benefit and a thicker 
Bigelow on the floor. The cost of any of these alternatives net of 
tax deductions to the corporation will almost surely be different 
from one another. 

In terms of making a decision to grant options or to do 
something else, the cost of all of the possible alternatives must 
be considered. If one is attempting to evaluate the wisdom or 
efficiency of a decision to grant options, the cost of other actions 
which could have been taken is relevant to the analysis. How- 
ever, one cannot make an easy generalization about what the 



n D. M. Hall and W. G. Lewellen, "Probing the Record of Stock Options, 
Harvard Business Review, Vol. 40, No. 2 (March-April, 1962). 

135 



Contemporary Corporate Accounting and the Public 

alternative would have been and one can be quite sure that its 
cost would not be equal to the opportunity cost of the option. 
Selection and costing of an alternative to a stock option involves 
some highly subjective considerations and some important as- 
sumptions. And the facts and assumptions will be different for 
each executive. Consequently, the objectives of accounting seem 
best served by limiting the definition of the cost of the options 
to the value of the lost opportunity to sell the stock to someone 
else. 

Determination of Cost 

Actually, to implement the concept of cost presented above 
requires determination of the point at which the corporation 
loses the opportunity to sell the stock to someone other than 
the holder of the option. The market value, which is the basis 
for measuring the opportunity cost, is determined at that date 
prior to which the opportunity has not been lost and after which 
the opportunity no longer exists. In most discussions, three dif- 
ferent dates are considered. 

1 . The date the executive is granted the option. 

2. The date the executive can exercise the option under the 
agreement and under relevant tax law. 

3. The date the executive actually exercises the option. 12 

Grant Date 

The current official position of the AICPA Committee on 
Accounting Procedure, as indicated in Bulletin #43, Chapter 



12 A fourth date, when stock acquired under option is sold, is sometimes con- 
sidered, but it seems completely irrelevant since after purchase of the stock 
the position of the executive holding the stock is essentially that of an 
ordinary stockholder: decisions to hold or to sell are purely personal invest- 
ment decisions and are in no way different from those made about stock 
acquired with cash received as a bonus, for example. The peculiar link with 
the corporation which characterizes a stock option is broken as soon as the 
stock is paid for and subsequent changes in the value of the investment are 
entirely the result of the executive's financial shrewdness or luck, as the case 
may be. In fact, the after-tax benefit of a stock option will always be partly 
a result of the executive's investment decision rather than entirely accruing 
from corporate munificence, because he cannot realize the tax benefit in- 
volved unless he holds the stock for at least six months after purchase. 

136 



COMPENSATION 

13, is that cost of stock options to the issuing corporation is the 
difference between option price and fair market value on the 
date the option is granted. The committee's reasoning is indi- 
cated in the following excerpt from the bulletin: 

. . . The date on which an option is granted to a specific indi- 
vidual would be the appropriate point at which to evaluate the 
cost to the employer, since it was the value at that date which the 
employer may be presumed to have had in mind. In most of the 
cases under discussion, moreover, the only important contingency 
involved is the continuance of the grantee in the employment of 
the corporation, a matter very largely within the control of the 
grantee and usually the main objective of the grantor. Under such 
circumstances it may be assumed that if the stock option were 
granted as part of an employment contract, both parties had in 
mind a valuation of the option at the date of the contract; and 
accordingly, value at that date should be used as the amount to be 
accounted for as compensation. 

This measure of cost does not fit the criteria given earlier, 
for the corporation in granting the option has not given up the 
opportunity to sell the stock to someone else. It has agreed that 
it will give up the opportunity at some future date if certain 
conditions— principally continued employment— are met, but 
this is not the same as actually giving up the opportunity and 
thereby incurring a cost. The practice of canceling options in 
a period of declining market prices is a good indication that there 
is nothing very final about the date of granting an option. Basing 
cost on the date of granting the option has the virtue of leaving 
no loose ends to be tidied up at some future time. However, 
untidy though it may be, it is true that the basic criterion for 
establishing the value which the corporation gives up— which 
is the cost of granting the option— is not known at the time the 
option is granted. 

Date Exercised 

The dates on which the option can be exercised and on 
which it is exercised presumably will be the same in a great 
many cases. If the option holder is short of funds to purchase 
the stock, or if he anticipates a decline in the market price before 

137 



Contemporary Corporate Accounting and the Public 

the date the option expires, he may defer exercising the option. 
He gains nothing by delaying if he has the money and if he 
expects a rising or stable market price. Indeed, since he must 
hold the stock for six months to get special tax treatment, it is 
advantageous to buy immediately in order to be in a position of 
freedom of action with tax benefit intact as soon as possible. 

If for the reasons given above the date of exercising the 
option is later than the date at which it became exercisable, the 
former is the one which fits the definition of cost given here. 
The corporation does not irrevocably give up the right to sell 
the stock to someone else and therefore incurs the cost of lost 
opportunity until the employee has exercised his option and 
purchased his stock. On the exercisable date the employee has 
a complete right to use his option, but the use of that right is 
contingent upon continued employment. (To obtain special 
tax treatment, the executive must use the option within three 
months after ceasing to be an employee of the corporation. In 
most option plans the corporation requires continued employ- 
ment as a condition of exercise.) 

It is true that holding but not exercising the option involves 
an essentially personal investment decision on the part of the 
employee. However, it is a decision not to buy and as such has 
no effect on the opportunities of the corporation. Only when 
the decision to buy is made and implemented does the corpora- 
tion lose the opportunity whose value is its cost of granting the 
option. The difference between the price at which the stock is 
sold under the option and the price for which it could have 
been sold in the open market on the date of sale is the before- 
tax cost of the option to the corporation. 

Annual Deductions 

There is some objection to this procedure because it defers 
accounting for a corporate decision until sometime in the 
future. 13 This objection has led to various proposals for making 



"For fuller statements of this view see W. R. Ruby, "Accounting for Em- 
ployee Stock Options," The Accounting Review, Vol. XXXVII, No. 1, 
(January 1962), and Edwin D. Campbell, "Stock Options Should be Valued," 
Harvard Business Review, Vol. 39, No. 4 (July-August, 1961). 

138 



COMPENSATION 

an annual deduction for stock-option cost during the period the 
option is in force. One way of doing this would be to use the 
market price of the corporation's stock on each accounting date. 
The difference between it and option price would be "cost for 
the year." The other approach suggested is to estimate what 
market price will be on the exercise date and thus estimate cost. 
This cost would be considered as a deferred expense and would 
be proportionately deducted from realized gross revenue during 
each year the option was outstanding. A terminal adjustment 
would be required to bring the forecast and actual market 
values together on the exercise date. 

Either of these procedures certainly conforms to the tra- 
ditional accounting procedure of matching expenses with the 
accounting periods which receive the benefit. Or they do this 
if someone who can predict stock market behavior three, four, 
or five years hence can be found. (After the stock-market break 
of May and June, 1962, one must reflect upon the many easy 
generalizations about the use of future stock prices in accounting 
and in business decision making generally which have filled the 
literature and poured forth from the lecture platforms since the 
end of World War II. I hope my students do not regularly 
refer to their old class notes.) In light of the possibility of 
extreme disparity between estimated or interim market prices 
and market price when the option is exercised (if it is exercised) 
a procedure for annual charges seems a generally uncertain re- 
finement. This is particularly so when one considers that full 
disclosure of the details of options outstanding can and should 
be included in all corporate reports. (See below.) Evaluation of 
the efficiency and wisdom of the use of stock options must 
utilize, among other things, knowledge of the cost of the options 
to the corporation, and this can be known with tolerable certain- 
ty only when the cost is actually incurred. 

Market Value 

One matter, of limited concern in terms of the large corpora- 
tions which are the subject of this book, remains to be disposed 
of. The measure of cost of stock options outlined here assumes 

139 



Contemporary Corporate Accounting and the Public 

the existence of a market value of the corporation's stock. For 
many smaller corporations, and for some larger ones, there may 
be no market value as such because the stock is not regularly 
traded. In such cases the stock must be valued on the date of 
sale by the accountant or some other qualified and independent 
person. All the usual problems of valuation will be faced, but 
they are no more insurmountable in this case than in any other. 

Disclosure 

Pensions and stock options are not the only devices for com- 
pensation which have been developed in recent decades primarily 
in reference to high personal-income tax rates. In addition to 
various types of insurance, there are liberal expense accounts and 
devices for deferring compensation. Under one form of arrange- 
ment part of the executive's contracted compensation is not paid 
to him until after he is sixty-five and retired. Because his post- 
retirement income will be smaller than his preretirement income, 
it will be taxed at a lower rate. The postretirement consultant 
is becoming a fixture of the corporate scene, for executives are 
given contracts for consulting services to be rendered (and paid 
for) after retirement. That some of these contracts are transfer- 
able to the executive's wife after his death is perhaps an indica- 
tion of the quantity and quality of service expected. 

The actual accounting for these other forms of compensation 
involves no particular problems, for the sums paid will be in- 
cluded in the corporation's expenses. The problem, or rather the 
absolute necessity, is that all details of these transactions be fully 
disclosed to all who have an interest in the corporation. Precise 
rules to cover all situations are difficult to specify, but as a 
minimum the full details of all of the compensation of all senior 
officers of a corporation should be disclosed in its regular reports. 
Certainly, the details of any out-of-the-ordinary forms of com- 
pensation such as stock options, bonuses, and deferred compensa- 
tion should be publicized. In the case of stock options the 
number of shares under option, the option price, and the market 
price of the stock at the date of the report should be disclosed. 

It can be argued that it is unfair, in many ways, to the 

140 



COMPENSATION 

corporation executive to require that his personal remuneration 
be made a matter of public knowledge. However, as Louis 
Brown said in the passage quoted in the beginning of this book, 
a manager "functions on the basis of a trusteeship" and is "ac- 
countable to his working organization, to his customers, and to 
the public." In matters of compensation, management is, for all 
practical purposes, dealing with itself. The traditional arm's 
length, that rather quaint but useful lawyer's concept, is con- 
siderably shortened in the case of management compensation. 
In an area where the possibility, which is not to say the actuality, 
of self-serving exists, accounting must be fullest. Disclosure may 
be unfair, but it is surely a part of trusteeship, of accountability, 
and of responsibility. 



141 



(^hap ter C* lev en 

INTANGIBLE RESOURCES 

i 

Emerson may have been right about the mousetrap in nine- 
teenth-century America, but in our time the race toward business 
success is less likely to be won by him who can make things than 
by him who can make people buy things. As partial vindication 
of Emerson's prescience, however, he who can discover new 
things which people can be made to want to buy is even more 
likely to be a winner. 

Consider soap. People have been making soap since pre- 
Roman times. It is an overstatement to say that anyone can make 
soap on a commercial scale, but to do so requires neither the 
skill involved in making electronic computers, for example, nor 
the capital required in making steel. Soap making is relatively 
simple, yet most of our soap is made and sold by three corpora- 
tions. Success in the soap business is surely dependent on the 
ability to make people buy a particular brand of soap. Names 
like "Ivory," "Palmolive," "Lux" are far more important re- 
sources than are soap kettles and inventories of fats and oils. 

Consider Scotch Tape. With the first marketing of that 
product America had not only a new way of fastening things; 
it had a new word. My children and their friends regularly 
use the verb "to scotch tape" and just as regularly use the ad- 
jective "scotch taped." The Minnesota Mining and Manufac- 
turing Company was one among a number of moderate-size 
companies making sandpaper and other abrasives at the time it 
introduced Scotch Tape. The success of this new product and 
continued development of new products have transformed it 

142 



INTANGIBLE RESOURCES 

into a major industrial organization. Success started with finding 
a new product people would want to buy. 

Twenty-five years ago public relations men were largely 
concerned with the field of entertainment. Today they are often 
as deeply involved in many corporate decisions as are the pro- 
duction, marketing, and financial experts. Creation and mainte- 
nance of a good "corporate image" is now a major concern of 
corporations and business decisions are carefully studied for 
their possible effect on the corporate image. 

In our consumption-oriented society, competitive position 
and growth, even survival, seem to be as much dependent upon 
the corporation's ability to induce consumption by promoting 
existing products and by discovering new ones as on the tradi- 
tional ability to produce a good product at a competitive price. 
The resources required to find new products and to induce 
consumption are at least as important as the resources required 
for production. Yet because these resources are generally in- 
tangible, in the sense that they do not have the obvious substance 
of factories, lathes, calculating machines, cash, etc., they are 
given far less attention by accountants and most others interested 
in the corporation than are financial resources and resources 
required for production. Given the importance of the large 
corporation in our society, the attendant needs of investors, em- 
ployees, customers, suppliers, and the public generally for re- 
liable information about the corporation are great indeed. 
Consequently, the lack of such information about important 
corporate resources and important corporate activities is par- 
ticularly grievous. 

II 

There are two broad classifications of intangible resources: 
those related to some sort of contractual arrangement and those 
usually labeled "good will." Contractual intangibles are such 
things as patents, licenses, copyrights, leases, etc. These generally 
represent a legal right to possess something or to do something 
—a legal monopoly in the case of patents and copyrights, the 

143 



Contemporary Corporate Accounting and the Public 

use of processes or facilities in the case of licenses or leases. The 
legal right is normally held for a specified and limited time. 

Good will is a name given to earning power whose source 
cannot be specifically identified. It may result from successful 
research and development, from a trade name or a good corpo- 
rate image, from an efficient distribution system or manu- 
facturing know-how. Such a listing could be extended almost 
indefinitely. The important thing is that the earning power of 
most successful corporations cannot be attributed entirely to 
the financial resources, to the buildings and equipment and in- 
ventories it owns or controls. This "extra something" is what is 
called good will. 

Actually, the difference between good will and contractual 
intangibles is not so great as is implied by the distinction made 
here. The possession of some legal right has economic values 
only if the right is a source of potential earning power. A patent 
on a machine for making horseshoes is certainly an exclusive 
legal right, but it is hardly a significant business resource in 
1962. A patent will undoubtedly increase the value to its owner 
of an otherwise successful product, but it will not make the 
product successful. Thus the value of contractual intangibles, 
when they have any value at all, is in large measure related to 
good will. 

The value and the economic life of intangibles are inextrica- 
bly related. Where there is value there is life. Where there 
is life there is value. In the case of intangibles, both value and 
economic life are highly uncertain matters. A well-known brand 
name can disappear virtually overnight. Several generations of 
good will ("Ask the Man Who Owns One") did not save 
the Packard automobile. A product which gives every promise of 
being a great success may finally be a complete failure, in 
which case the research which went into it and the patent which 
protects it from competition are basically without value. The 
tremendous development and promotion of the Edsel earned no 
profits. On the other hand, highly successful products such as 

144 



INTANGIBLE RESOURCES 

"Toni" home permanent waves and "Lestoil" liquid cleaner 
rocketed the value of small and previously obscure companies. 
Economic life and value of intangible resources are among the 
most uncertain of all business facts. 

Even where a patent is involved, life and value are uncertain. 
A patent gives the holder a legal monopoly over a product or 
process for seventeen years. However, the ultimate value of the 
patent depends on the marketability of the patented process 
or product. The market may disappear well before the end of 
the seventeen years, or may extend well beyond that time. (In 
the latter case, value to the patent holder would surely decline 
after seventeen years because the market would have to be shared 
with competitors.) 

Intangible resources may be purchased by a corporation from 
another owner or they may be developed by the corporation 
itself. Patents and trade-marks are sometimes purchased directly. 
Good will most frequently changes hands as a result of the 
purchase of one company by another. In such cases, the price 
paid for the purchased company exceeds the value of its net 
tangible resources and this excess presumably represents the 
value of its good will. Good will which has been developed by 
a corporation presumably results from the expenditure of re- 
sources on advertising and promotion, research and development, 
administrative talent, etc. Ultimately, of course, the value of 
an intangible resource (or any other kind of resource) is quite 
independent of how it came into the possession of its owner. 
The value, at any time subsequent to its acquisition, of a ma- 
chine made by a company for its own use is not, for that reason, 
different from the value of a similar machine purchased from 
another. And in this sense, a brand name, for example, is no 
different from a machine. This distinction between purchased 
intangibles and "home-grown" intangibles is made here only 
because it is a distinction generally made in contemporary ac- 
counting practice. The distinction is not relevant to the later 
discussion of alternatives to this practice. 

145 



Contemporary Corporate Accounting and the Public 
III 

CONTEMPORARY ACCOUNTING PROCEDURES 

Characteristically, extreme caution has been the general re- 
sponse of accounting to the uncertainty which surrounds the 
existence and the value of intangible resources. In no other area 
of accounting is the convention of conservatism so much re- 
lied upon. Avoiding the risk of overvaluation is sought through 
deliberate undervaluation. In this, as in other areas, accounting 
is extremely permissive for one can choose from among recog- 
nized procedures which will give virtually opposite results. A 
recent study 1 suggests that the extreme permissiveness charac- 
terizing accounting for intangible resources can, in the aggregate, 
affect corporate net income in the United States by as much 
as $5 billion annually, depending upon accounting methods se- 
lected. 

Resource Valuation 

Historical acquisition cost is the usual basis for the valuation 
of intangibles— that is, the price paid for the intangible provides 
the quantitative basis for accounting. In the case of good will, 
the purchase transaction also provides the basis for recognition 
of the resource— which means that good will is not recognized 
in the accounts and statements of a corporation unless it has 
been purchased. For example, when a corporation purchases a 
successful brand name from a smaller competitor there is a con- 
ventional sale and purchase transaction and the price agreed 
upon provides a historical cost upon which to base accounting 
for a trade-mark. But what of the brand name developed by a 
corporation through an advertising and promotion campaign 
carried on over several years? In such cases, the costs of the 
campaign are included among operating expenses as they are 
incurred and there is no historical cost in the conventional sense. 
If an intangible resource is purchased outside the corporation, 
it is recognized and valued in the accounts. If the same intangible 



1 Stephen H. Wales, "Intangible Expenses and Amortizing Intangible Assets, 
Accounting Review, Vol. XXXVII, No. 1 (Jan. 1962). 

146 



INTANGIBLE RESOURCES 

resource is developed within the corporation, it is neither recog- 
nized nor valued in the accounts. 

An exception to the foregoing is usually found in the case 
of contractual intangibles. When a patent, for example, is taken 
out on a product or process developed by the corporation itself, 
the legal, clerical, and other costs associated with obtaining the 
patent are typically taken as the value of the patent which is 
included among the company's resources. Nevertheless, this 
accounting valuation of such a patent is almost surely different 
from the valuation of the same patent purchased from an out- 
sider, for the price paid in the latter case would surely be based 
on expected future earnings. 

Income Determination 

In theory, operating costs associated with intangible re- 
sources are taken into net income in accordance with the rules 
for matching income and expense. Costs are deducted from 
gross income realized as a result of the expenditure. In practice, 
this rule is not always followed. The treatment of intangibles 
not purchased described above is an obvious exception. In that 
case, the costs associated with the intangible are, in effect, de- 
ducted before the intangible actually comes into being. For 
example, the development of a new product may involve several 
years of work in the corporation's laboratory before it can be 
marketed. However, the development costs associated with the 
product have been deducted from gross income before any in- 
come is realized from the product. 

In the case of intangibles purchased from others or of costs 
associated with contractual intangibles developed by the corpora- 
tion itself, a variety of procedures is available and all are used. 
The costs are sometimes deducted from gross income upon 
acquisition. That is, acquisition costs are written off immediately. 
In other cases, the costs are deducted according to some pre- 
determined schedule. For example, amortization over seventeen 
years is common in the case of patents, no doubt because of the 
seventeen-year life of the patent. In other cases where there is 
no legal life to rely upon, an arbitrary period of ten years or 

147 



Contemporary Corporate Accounting and the Public 

twenty years or some other time is used. Finally, in some cases 
intangibles, especially good will, are never written off. This is 
often the case with so-called "Good Will Arising from Consol- 
idation." Amortization of good will is not permitted in the de- 
termination of taxable income, a fact which may bring about 
this accounting treatment. 

In summary, then, it can be said that accounting for intangi- 
ble resources is quite thoroughly confused. If the intangible is 
purchased from another, it will be accounted for in one way or 
another. If it has been developed by the corporation itself it may 
not, in effect, be accounted for at all. Operating costs associated 
with intangibles may be deducted from income before the in- 
tangible actually exists, at the time it is acquired, after it is 
acquired, or never. Truly a procedure for every taste! 

IV 
THE RATIONALE OF ACCOUNTING PROCEDURES 

An explanation of this profusion of accounting procedures 
must begin with another acknowledgment of the uncertainty 
which characterizes most intangibles. For example, few people, 
including most accountants, would deny that good will does 
exist, that most corporations have value not reasonably attributa- 
ble to tangible resources. Yet unless it has been purchased and 
paid for, the accountant is left without any conventional proof 
of its existence or of its value. One can say that ABC Corpora- 
tion has good will, but one cannot be sure. There is no piece 
of paper— no bill of sale or voucher— to support the assertion. 
In such circumstances, the conservative thing to do is to ignore 
the matter entirely. (It can be argued that even purchase and 
sale do little to establish the value of good will. They do prove 
that someone has been willing to pay good money for something 
other than tangible resources, but while the amount of money 
may establish historical cost for accounting purposes the un- 
certainty surrounding good will has not really been eliminated. 
Its value is a chancey thing and the purchaser may be just as 
wrong as the seller might have been.) There is no doubt that 

148 



INTANGIBLE RESOURCES 

valuation of good will developed by a corporation involves un- 
certainty. The fact that the good will was not purchased, how- 
ever much comfort may be taken from the independent confirm- 
ation of value implicit in purchase or sale, does not seem sufficient 
grounds for ignoring it. 

The same considerations are relevant to handling intangibles 
in income determination. There is no doubt that the probable 
economic life of an intangible resource cannot be estimated with 
any great certainty. The "safe," the conservative thing to do in 
such a case is to deduct all costs immediately. Since we do not 
know over what period they should be deducted, it is more 
conservative to get them all deducted before the good will 
becomes valueless and we find ourselves reporting it as if it 
still had value. In a great many cases, good will probably in- 
creases in value as time goes on, which means that accounting 
involving immediate or short-term writeoffs is most unrealistic. 
As Joel Dean has put it, "As markets are established and profits 
come in, the good will is written off the books. Thus paper 
good will may be written off as the real good will builds up." 2 

Accounting for intangibles involves two risks. One is the 
risk of reporting a resource which does not exist. The other is 
the risk of not reporting a resource which does exist. The as- 
sociated risks are those of not recording costs which have been 
incurred or of recording costs which have not been incurred. 
In the name of conservatism accountants have almost always 
tried to achieve a complete hedge against the risks of reporting 
nonexistent resources and of not recording incurred costs. In 
so doing they have almost surely been extremely misleading 
about the real value of our corporations. 

Discrimination 

Accounting procedures for intangible resources and related 
tax regulations may discriminate significantly in favor of a 
certain type of corporation. The problem here concerns growth 



2 Joel Dean, Managerial Economics (Englewood Cliffs, N. J.: Prentice-Hall, 
1951), p. 15. 

149 



Contemporary Corporate Accounting and the Public 

and its relationship with net income. For purposes of illustration, 
assume that one corporation maintains its competitive position 
largely through promotion and that another does so largely 
through production. If both corporations are striving to grow 
as well as to maintain competitive position, the promotion corpo- 
ration has a decided accounting and tax advantage. It can make 
expenditures on promotion aimed entirely at fostering growth 
and deduct these expenditures from current gross income both 
for accounting purposes and for tax purposes. It does not have 
to worry about distributing the money required to maintain 
competitive position and foster growth to the tax collector, the 
stockholder, the customer, or the worker. The production 
corporation is in a quite different position. Competitive position 
and growth may depend upon the purchase of more and better 
—and more expensive— machinery, but it must compute its net 
income on the basis of the costs of machinery acquired years 
before. The tax collector and the worker, the stockholder and the 
customer all make demands on the profit this company needs for 
the maintenance of competitive position and growth. Small 
wonder that most of the outcries against contemporary account- 
ing practice come from the heavy manufacturing companies 
such as steel. 3 

Corporations relying largely upon advertising and promotion 
and research and development are able to state their net income 
more or less in accordance with a competitive position concept 
of net income. That is, many of the costs they are permitted to 
deduct from realized gross income are costs incurred in main- 
taining the corporation's competitive position in the future 
and thus their net income is, in part, the residue of realized 
gross income after deduction of the costs of maintaining competi- 
tive position. Corporations whose position depends largely on 
their productive resources are generally stuck with the historical- 



3 Both production corporations and distribution corporations are equally able 
to charge off research and development expenditures, and to the extent that 
these play an important part in maintaining the position of either type of 
company no discrimination is involved. 

See, for example, Accounting mid Reporting Problems of the Accounting 
Profession (Chicago: Arthur Anderson and Co., 1960), section 12. 

150 



INTANGIBLE RESOURCES 

cost concept of income. Their net income is the residue of 
realized gross income after deduction of some arbitrary portion 
of historical monetary costs. These historical monetary costs 
only infrequently bear any relationship to the costs of maintain- 
ing current competitive position and thus these corporations 
are in a considerably less favorable position, vis-a-vis promotion 
corporations, simply because of accounting. 



Broadly speaking, there are three possible approaches to 
improving contemporary accounting for intangible resources. 
These will be discussed below, but none can be recommended 
without considerable qualification. Much more research into ac- 
counting for intangibles is needed, and especially is there needed 
a willingness to experiment with new approaches. The following 
procedures are suggested as bases for such experimentation and 
research. 

One approach to intangibles is to proceed with extreme 
conservatism and, in effect, do no real accounting at all. All 
current expenditures for research, promotion, etc.— indeed all 
expenditures except those for inventory and fixed-asset acquisi- 
tion—would be written off when the expenditures were made. 
The direct purchase of intangibles from another would also 
be immediately written off. No intangible resources would be 
shown on corporate balance sheets. All outlays associated with 
intangible resources would be written off as made regardless of 
when benefit from expenditures is expected. 

About the only advantage this procedure has (but it is an 
important advantage) is to insure comparability among company 
statements. It would avoid entirely the uncertainty which in- 
evitably surrounds contemporary accounting procedures. One 
would at least be sure of what he is not reading in corporate 
reports. Beyond this, the procedure is rather like that of eliminat- 
ing sin by legalizing it. If it were adopted it would mean that 
extremely important resources would not be recognized, and 
any reasonable matching of revenue and expenses would be out 

151 



Contemporary Corporate Accounting and the Public 

of the question. It can be considered an improvement over 
present uncertain procedures but not a substitute for positive 
and meaningful accounting for intangibles. 

A second approach is to attempt direct evaluations of in- 
tangibles based on the costs of acquiring them. In the case of 
purchased intangibles— good will, patents, licenses, etc.— this 
is the procedure usually followed in contemporary practice. 
Accounting for "home-grown" intangibles would involve a 
capitalization of at least that portion of current expenditures 
which can be reasonably related to future benefit. That is, the 
costs of research on a product which will not be perfected for 
a number of years should not, it is suggested, be deducted from 
current gross income. Rather these costs should be carried for- 
ward to those future periods when income from the product 
will be realized. At that time, the costs would be deducted in 
accordance with the expected life of the product. The costs of 
advertising designed to create markets, perpetuate brand names, 
and the like would be treated in much the same way. 

The foregoing proposal has a great deal of merit primarily 
because it would achieve a far better matching of revenue and 
expense. Costs would be deducted from income during the time 
period when the resources were actually producing income. 

A principal difficulty with this approach is the necessity of 
isolating several different elements implicit in aggregate current 
expenditures. Some of these are for the creation of future in- 
come-producing resources. Other parts of current expenditure 
are simply for the maintenance of existing intangibles. Intangible 
resources must be maintained just as machinery must. A brand 
name must be constantly promoted if it is to continue to attract. 
Patents often require the protection of further patents on substi- 
tutes. The corporate image can become tarnished quite quickly 
in the absence of constant attention to it. Finally, some expendi- 
tures made for future benefit will not be realized. For example, 
by mid- 1961, General Dynamics Corporation had recognized 
that some $425 million spent in previous years on the develop- 

152 



INTANGIBLE RESOURCES 

ment of its Convair 880 and 600 aircraft was, in fact, a total loss. 4 

Furthermore, this procedure does not help particularly dur- 
ing the period in which the intangibles are being used to produce 
income. It is usually suggested that research and development 
expenditure, for example, be deducted from income over the 
estimated life of the product, but what is the life of a new 
product? How long will a brand name continue to produce 
income? Does its power to produce income decline gradually 
or does it expire suddenly and unexpectedly? Any scheme of 
amortization requires a reasonable estimate of life and, if re- 
source values on balance sheets are to have meaning, a reasonable 
prediction of decline in value. It seems unlikely that either of 
these requirements can be met in the case of intangible resources. 

One very important thing this procedure would accomplish 
would be to eliminate in some measure the unwarranted dis- 
tinction made between intangibles developed by the corporation 
and those purchased from others. In both cases the existence 
of the intangibles would be recognized and costs would be de- 
ducted while income was being realized from the intangible, 
albeit imperfectly. 

The third possible approach to accounting for intangibles 
is to work with present values. 

There is, after all, no area of accounting where the complete 
irrelevance of historical cost is more obvious. Intangible re- 
sources—especially good will— are almost by definition the pres- 
ent value of future earnings from generally indeterminate 
sources. The cost of obtaining a patent, of developing a new 
product, of a campaign to improve the corporate image has 
very little to do with the value of the patented product, the new 
product, or the corporate image. Yet because the exact sources 
of this earning power are not always known, it is not possible 
to measure their present value. Nor can we resort here to replace- 
ment value as a substitute for present value as may on occasion 
be done with fixed assets, for example. Replacement value in- 



4 Richard Austin Smith, "How a Great Corporation Got Out of Control, 
Fortune, Vol. LXV, Nos. 1, 2 (January and February, 1962). 

153 



Contemporary Corporate Accounting and the Public 

volves identification of the resource to be replaced and one does 
not always know what the particular intangible is. 

The present value of intangible resources can be determined 
by deduction from the aggregate present value of the corpora- 
tion. If the present value of financial resources, of inventories, of 
fixed assets, and of other known resources is deducted from the 
present value of the whole corporation, the difference should 
equal the value of the intangible resources of the corporation. 
The problem, of course, is to achieve a satisfactory method of 
measuring the present value of the corporation. The market 
price of the corporation's stock is one possible approach. An- 
other is simply an estimate by the corporation's management. 

Over the long run, the market price of a corporation's stock 
should represent the present worth of the corporation's estimated 
future earnings, assuming acceptance of the market's appraisal 
of risk. In the short run, of course, the market is subject to a 
variety of essentially extraneous factors (Eisenhower's heart 
attack, Sputnik, etc.). Consequently, a considerable amount of 
judgment is involved in selecting a market price, and it would 
undoubtedly be necessary to utilize average prices over some 
reasonable period of time. 

There may also be a certain amount of circular reasoning 
involved in basing the present value of corporations on the mar- 
ket price of their stock. Investors' decisions to buy or sell se- 
curities are largely based on two sources of information— in- 
formation about expected behavior of the economy as a whole 
and information about the present status and expected future 
progress of the corporation in question. This latter source of 
information is precisely what we are considering here. To the 
extent that intangible resources are not recognized or are grossly 
misvalued in corporate reports and statements, the investor must, 
of course, guess about their worth. Since the guess will not in 
most cases be an informed guess, it is of doubtful validity as a 
basis for valuing intangibles. 

Management estimates of the value of the corporation are, 
of course, subject to abuse. The open invitation to appear as 
one would like to be rather than as one is, is apparent. The value 

154 



INTANGIBLE RESOURCES 

of intangibles is, more than the value of other resources, the 
result of management effort, and the desire to show this effort 
as effective would no doubt be strong. Furthermore, the problem 
of relative optimism or pessimism may unintentionally— even un- 
wittingly—be involved. With a Republican in the White House 
valuation might tend to be optimistic and relatively high— at 
least when made by Republican managers. The gloom that a 
Democratic president seems to cast over most executive dining 
rooms would surely find its way into valuations. 

On the other hand, management has available more and better 
information than anyone else. Management decisions about ad- 
vertising and promotion programs, research and development 
activities, decisions to purchase a patent or a brand name must 
involve some contemplation of the present value of the corpora- 
tion and the effect of the decision thereon. (Such contemplation 
may be most informal and rough, but constant improvements in 
ability to collect and process data and in the art of using these 
data result in increasingly sophisticated contemplations.) The 
essential fact is that management, because of the information 
it has, is in the best position to estimate the present worth and 
thereby the value of intangible resources of the corporation. 
Furthermore, it would be an important function of the public 
accountant to test the reasonableness of management estimates, 
utilizing his knowledge of the particular corporation, his ability 
to compare estimates with those made by other clients, and a 
knowledge of business conditions generally. The characteristic 
caution of most accountants should act as an antidote to either 
excessive optimism or excessive pessimism. 

If the value of intangible resources is determined as suggested 
above, the procedure to be used in income determination fol- 
lows quite obviously. The change in the present worth of the 
intangibles from one period to the next, plus or minus current 
expenditures on advertising, research, contributions and all the 
other things which enter into the creation of intangibles, would 
be the income or expense associated with the intangibles. Such 
a procedure would eliminate the problem of separating out of 
current expenditures those which are solely for maintenance of 

155 



Contemporary Corporate Accounting and the Public 

existing intangibles rather than for the creation of new ones. In 
some instances, there would be a net increase in the value of 
intangibles and therefore income (in the conventional sense) 
rather than expense. This would create a need to recognize the 
difference between increases in capital and distributable income. 
The capital required to maintain the present competitive position 
of the corporation is just as real in the case of intangibles as 
it is in the case of cash, receivables, inventory, and plant. 
Without their brand names, their flow of new products, their 
image, few of our large corporations would occupy their present 
competitive position. Increases in such capital arising from in- 
creases in present worth of resources of the corporation need 
not be confused with distributable income. 



VI 

Reluctantly, one must conclude this discussion on a some- 
what tentative note. This is one of those situations where one 
can be far more forceful about crying with alarm than about 
suggesting how to put out the fire. It seems beyond dispute that 
intangible resources represent one of the major problem areas 
of accounting for the modern large corporation. Even though 
untried, the procedure just described is conceptually sound. 
There is no denying that it will, in a way, involve the intrusion 
into accounting of more subjectivity than has heretofore been 
tolerated. Attempts at implementation may indicate unsolvable 
problems, but subjectivity should not be one of them. It is, 
after all, a subjective conclusion that deliberate, albeit certain, 
undervaluation is preferable to an honest and intelligent esti- 
mate of real value. 

The present procedure for accounting for intangibles repre- 
sents typically a conservative reaction to uncertainty. In effect, 
it is based on the proposition that if one is not sure what value, 
if any, a particular resource will have and if one is not sure how 
long it will continue to have value if it does have any, the safe, 
conservative thing is to assume it has no value. But there are 
other possible reactions to uncertainty. Is it better to be virtually 

156 



Intangible resources 

certain of being wrong, or is it better to have a reasonable 
certainty of being right? Is it preferable to rely upon a piece of 
paper which is evidence of something which happened in the 
past, or is it preferable to rely upon the experience, intelligence, 
and integrity of accountants and managers in making estimates 
about the present and the future? In light of the vital social 
role of the corporation, every scrap of information about it that 
can be stated with a reasonable degree of reliability should be 
made available. Because our economy is so much based on con- 
sumption we can no longer afford to be ignorant of the resources 
required to induce consumption. The art of persuasion is no 
longer very gentle; the hard sell is ours to live with. Neither is 
it inexpensive, for vast amounts of capital are required to main- 
tain our levels of consumption. The extent of this commitment 
of resources must be known even if only with a limited degree 
of certainty. 



157 



L^hapter ^Jweli 



t 



wetve 



RESPONSIBILITY FOR 

ACCOUNTING: 

A SUMMING UP 



The twentieth-century capitalist revolution has brought the 
large corporation to the very center of our society. There is no 
doubt that these corporations and their managers are the repos- 
itory of enormous economic and social power. That this has 
come about quite without design or plan and that much of the 
power is unused— perhaps even unrecognized— by those who 
hold it is beside the point. It is there and it must be responsible. 
A key requirement in maintaining the responsibility of the 
holders of power is jto put information about the uses of that 
power into the hands of those to whom the responsibility is 
owed. It is in terms of this requirement that the foregoing de- 
scriptions and discussions of contemporary accounting for the 
status and progress of large corporations have been made. It is 
not suggested that financial information— the particular province 
of accounting— is the sum total of information required. How- 
ever, it is true that a very great deal of what corporations do or 
do not do is ultimately expressed in financial terms. Financial 
information, broadly defined, has a critical role in the evaluation 
of corporate status and progress. 

The coverage in the foregoing pages of controversial areas of 
contemporary accounting has by no means been exhaustive, but 
those areas discussed are generally illustrative and are of broadest 

158 



RESPONSIBILITY FOR ACCOUNTING: A SUMMING UP 

importance. The conceptual and procedural details have changed 
from chapter to chapter, but hopefully the reader will have ob- 
served a number of fundamental problems underlying every one 
of the specific issues. 

In the first and most important place, there is the need for 
accounting to re-examine from time to time its basic role in our 
society and the way it is carrying out that role. Much of ac- 
counting's development seems mostly to have been a steady 
tinkering with nuts and bolts rather than a complete overhaul 
of the basic machinery. In the words of Leonard Spacek, a most 
persistent and articulate advocate of change and improvement in 
accounting: 

Instead of standard of measurement, attention is focused on tech- 
niques. Most documents are overburdened with procedural com- 
ment on how to handle certain transactions, but little is said about 
the effect sought and still more important— why. 1 

It is always important for any individual or organization to 
ask itself "why" and never more so than for accounting in these 
days of rapid and extreme change in the role in society of the 
corporations being accounted for. 

In the second place, there is an obvious need for accounting 
to be able to change its procedures in accordance with the re- 
sults of such basic re-examinations as those suggested above and 
in the face of changes in particular business conditions or tech- 
niques. 

A third problem, closely related to the second, is the neces- 
sity to achieve uniformity and to ensure disclosure of all relevant 
data. The need to develop new procedures has as a corollary the 
necessity for discarding old ones. Failure to do so is an important 
cause of lack of uniformity. 

Finally, the inevitability of uncertainty has been a factor in 
all the problems discussed in this book. Living with uncertainty 
is largely a matter of understanding and attitudes rather than of 
organizations and machinery, and discussion of this matter is 



Leonard Spacek, "The Need for an Accounting Court," The Accounting 
Review, Vol. XXXII, No. 3 (July 1958), p. 369. 

159 



Contemporary Corporate Accounting and the Public 

deferred until later in this chapter. The first three of these prob- 
lems—the need to re-examine the basic role of accounting, the 
need to adopt new conventions and procedures as required, and 
the requirement for a reasonable degree of uniformity and a 
necessary degree of disclosure— are all related in the sense that 
they exist because of the way the accounting profession is or- 
ganized and functions. 

The objectives and procedures proposed in this book seem 
more in accord with the nature and role of the modern corpora- 
tion than those implicit in current accounting practice. Unfor- 
tunately, there seems to be no sure way in which these 
propositions (or anyone else's) can be considered, modified, 
accepted, or rejected by accountants. As Mr. Spacek has said, 
"Today there is no place where agreement on basic premises can 
be argued." 

The failure to resolve the controversy over price-level ad- 
justments, after more than fifteen years of fairly steady inflation, 
is an obvious outcome of an inability to re-examine the basic 
role of accounting and change procedures accordingly. The 
confused floundering which has been accounting's response to 
the rapid growth of stock options or leasing is a clear manifesta- 
tion of inability to resolve, even over ten years, an accounting 
problem created by a new business technique. 

As suggested before, accounting is largely subjective . Con- 
ventions and procedures generally cannot be labeled right or 
wrong. But the relative can be substituted for the absolute: the 
absence of a right procedure does not preclude the existence of 
a best procedure. Selection of a best procedure requires some sort 
of functioning selection machinery, just as uniform use of a best 
procedure requires machinery for enforcement. As the brief de- 
scription of the accounting profession which follows will show, 
there is no such machinery. The development and regulation of 
accounting theory and practice is basically the result of ad hoc 
expedients, largely dictated by the very corporations whose af- 
fairs are being accounted for. 

160 



RESPONSIBILITY FOR ACCOUNTING: A SUMMING UP 



To define the accounting profession is a virtually impossible 
task. The high-school lad who spends his Saturdays keeping the 
books for the corner grocer may call himself an accountant, as 
may hundreds of thousands of other people in and out of in- 
dustry and government who are involved in one way or another 
with financial record keeping. At a more significant level— that 
level involving the analysis, interpretation, and reporting of 
financial data and the development of principles and procedures 
for so doing— it is possible to distinguish four main groups of 
accountants. 

The first and largest of these are the employees of business, 
nonprofit organizations, and government. The Financial Execu- 
tives Institute, The National Association of Accountants, The 
Institute of Internal Auditors, and several associations of govern- 
ment accountants are among the more important of the pro- 
fessional societies representing this large and heterogeneous group 
of accountants. These people are for the most part only mar- 
ginally involved in that area of accounting being discussed here; 
their primary concern is with accounting data used in internal 
operating management. However, the senior accounting officers 
of a corporation play a key role in deciding the extent and the 
conceptual bases of the corporation's accounting to its several 
constituencies. 

A second, and much smaller group, are the teachers of ac- 
counting. Since few of these men are or ever have been practi- 
tioners, and since their qualifications are more likely to be 
academic than professional, it is possibly inappropriate to list 
them as accountants. However, some of these men have had a 
profound influence upon the practice of accounting through 
their research and publication as well as through their teaching. 
The American Accounting Association, the professional organi- 
zation of teachers of accounting, has through its meetings and 
publications made important contributions to the structure and 
practice of accounting. 

A third part of the accounting profession consists of members 

161 



Contemporary Corporate Accounting and the Public 

of a wide range of government agencies. Some of these agencies 
have power, granted by the legislation which created them, to 
prescribe accounting regulations in one way or another. The 
Securities and Exchange Commission has wide powers over 
accounting procedures and standards for corporations whose 
securities are publicly traded. The Interstate Commerce Com- 
mission, representative of a group of agencies, has complete 
control over the accounting of the carriers under its jurisdiction. 
Other government agencies do not have statutory power to 
specify accounting principles and practices but have great influ- 
ence through their other powers. The Internal Revenue Service 
is, of course, foremost among these and a number of instances in 
which its regulations concerning taxable income have influenced 
accounting generally were described in preceding chapters. 

Most important in terms of the matters being discussed here 
are the public accountants, some of whom are designated as 
Certified Public Accountants, many of whom are not. The 
Certified Public Accountants, particularly those members of the 
eight large firms which dominate the profession, 2 are the persons 
most directly concerned with the accounting for our large corpo- 
rations. These are the men who certify the statements of most of 
these corporations. The Accounting Research and Terminology 
Bulletins of their American Institute of Certified Public Ac- 
countants collectively represent the closest thing to an authori- 
tative statement of contemporary accounting principles and 
procedures. 

For the most part no laws grant Certified Public Account- 
ants a pre-eminence or authority over accounting. The regula- 
tions of the Securities and Exchange Commission and the several 
stock exchanges, as well as some state laws and some corporation 
charters, require statements of corporations to be examined and 
certified by an "independent" public accountant. This require- 
ment does give the public accountant, and especially the CPA's 



2 T. A. Wise, "The Auditors are Comming," Fortune, November, 1960 and 
December, 1960. These two articles contain an excellent description of the 
organization and functioning of public accountants. The second article also 
briefly discusses some of the problems which are the concern of this book. 

162 



RESPONSIBILITY FOR ACCOUNTING: A SUMMING UP 

as generally acknowledged leaders of public accounting, a cer- 
tain status and an implied responsibility for developing and 
maintaining accounting principles and procedures. It is only an 
implied responsibility, however, for the CPA has no authority, 
statutory or implied, over any of the other groups which make 
up the accounting profession. Even within the American Institute 
of CPA's "general acceptance" is the only real basis for 
authority. The membership has the authority to vote rules of 
practice, but has done so in only six relatively noncontroversial 
instances since 1932. 3 General acceptance, as illustrated by many 
procedures cited earlier, tends to mean "anything goes." 

Authority of Management 

Given the profusion and confusion of "professionals" just 
described it is not surprising that the real authority over account - 
i ng for corporations rests primarily with those who hav e the 
ultimate power — the managements of the corporations whose 
status an d progres s are bein g accounted for. Virtually all writ- 
ings concerned with corporate financial reporting begin with 
the disclaimer that the reports are managements' reports. The 
Introduction to the Accounting Reseach and Terminology Bul- 
letins puts it this way: 

Underlying all committee opinions is the fact that the accounts 
of a company are primarily the responsibility of management. The 
responsibility of the auditor [i.e. public accountant] is to express 
his opinion concerning the financial statements and to state clearly 
such explanations, amplifications, disagreement or disapproval as 
he deems appropriate. 

The nub of the whole problem of independent control of 
accounting by accountants is implicit in the last sentence of this 
statement. As Leonard Spacek has written with considerable 
candor, the accountant "can swallow his convictions or he can 
qualify his opinion, or he can resign. Usually the latter two 
courses are one and the same." 4 Public accountants are hired 



3 American Institute of Certified Public Accountants, Accounting Research 
and Terminology Bulletins (New York, 1961), chap. 1. 
4 Spacek, loc. cit., p. 371. 

163 



Contemporary Corporate Accounting and the Public 

and paid by the corporations whose records they are to examine 
and report upon. It is true that many corporate charters require 
election by stockholders, but in practice they are nominated by 
management and election is a matter of routine. The fact that 
public accountants are dependent upon managements for their 
livelihood is not in itself destructive of independent control over 
accounting standards. But the lack of any specific authority of 
their own combined with the lack of any external standards 
upon which they can rely does place the public accountant in 
a most ambiguous position vis-a-vis his clients. 

The Securities and Exchange Commission has accounting 
regulations in force (Regulation S-X and amendments compose 
the basic statement) but for the most part these are simply a 
restatement of generally accepted accounting procedures and 
as such reflect all of the ambiguities, permissivenesses, and un- 
certainties of these procedures. The commission clearly has the 
authority to state and require specific accounting procedures, 
but to date it has not done so. 5 The major stock exchanges also 
have what may be called minimum regulations, but these, like 
those of the SEC, are not independently determined. They are 
the same uncertain standards everyone else has. 

Without the sanction of recognized authority, the public 
accountant is in the position of having to rely almost entirely on 
his logic and his persuasiveness in supporting his judgment 
against that of his client. In many instances, the accountant's 
judgment will be in direct conflict with the apparent best in- 
terests of his client and it is therefore not surprising that to a 
very considerable degree accounting standards have, in fact, 
been set by the corporations whose affairs are being accounted 
for. This is not intended to impute wrong motives to corpora- 
tion managers. The fact is that accounting standards are in large 
measure set by bargaining between public accountants and 
corporation managers and in this bargaining the corporation 
managers hold the balance of power. When their best interests, as 



Tor a detailed discussion of the commission's accounting activities see L. H. 
Rappaport, SEC Accounting Practice and Procedure (New York: The Ronald 
Press Co., 1959), esp. Chap. 2. 

164 



RESPONSIBILITY FOR ACCOUNTING: A SUMMING UP 

they see them, are involved it is not surprising that they use the 
power to protect them. 



Ill 

The basic need is for objective and authoritative accounting 
standards which will serve the needs of all the constituencies of 
the corporation. Meeting this need can come only from a com- 
bination of greater discipline and authority within the account- 
ing profession and of independence of public accountants from 
the corporations whose affairs are being accounted for. 

Discipline and authority within the accounting profession 
are necessary to ensure that accounting concepts and procedures 
change and evolve as business conditions and practices change 
and evolve, and to ensure the uniformity and the degree of dis- 
closure modern conditions require. Quite simply, there must be 
some voice which, after adequate investigation of the problem, 
can say with authority, "This is the way this particular bit of 
accounting will be done." 

Independence of public accountants from corporations could, 
of course, be achieved by having public accountants appointed 
and paid by the public, as we do in the case of judges. However, 
this sort of independence would achieve little without the dis- 
cipline within the profession discussed above. Furthermore, a 
well-defined authority within the profession very likely would 
extend beyond the profession and thus bring about the desired 
independence. It is, after all, an independent body of accounting 
doctrine which is needed. Except as a means toward that end, 
independence of accountants as such is not important. 

At present the needed voice of authority exists in the SEC. 
No new legislation or machinery would be required. The com- 
mission could simply replace Regulation S-X with new regula- 
tions which in all cases set forth a specific procedure to be 
followed. In other words, decision of the commission would 
replace general acceptance by the profession. 

Another, and more attractive, possibility is the Accounting 

165 



Contemporary Corporate Accounting and the Public 

Court suggested by Leonard Spacek. 6 In essence, Mr. Spacek 
has proposed a panel of independent accounting experts, elected 
for life by the entire accounting profession. The court would 
be under the aegis of the AICPA but Mr. Spacek has proposed 
all sorts of guarantees of its independence. The court would 
consider all aspects of any particular question of accounting 
theory or practice (either on its own volition or at the request 
of others) and hand down a judgment which would, in effect, 
become the standard for accounting until subsequently revised 
by the court. The court's opinions would be accounting doctrine. 
Such a court would certainly provide the necessary authority 
within the profession. If it became sufficiently prestigious its 
authority would, no doubt, gradually extend outside the profes- 
sion. However, a combination of the probable thoroughness and 
independence of the accounting court with the authority of the 
SEC seems the most efficacious solution of all. If the opinions of 
the court were adopted by the SEC as a part of its accounting 
regulations their authority both within and without the pro- 
fession would be unquestionable. 

Such machinery would go far toward achieving the necessary 
independent body of accounting doctrine. Debate over account- 
ing concepts, principles, and procedures would be conducted 
without becoming involved with the question of effects on a 
particular client's reports and statements. Clients would be 
entitled to argue for or against a particular proposal before the 
court, but arguments would have to be on long-run and funda- 
mental questions, not on expediency of the moment. If such a 
court had been in existence during the past twenty-five years— 
quite independent and with adequate resources for research— it 
seems most likely that the sweeping changes which have taken 
place in the role of corporations would have been accompanied 
by a searching re-examination of the role of accounting. Many 
of the diverse and contradictory procedures in use today would 
surely have been eliminated. It would not have taken ten years 
to decide how to account for stock options. In short, there would 

e Spacek, loc. cit. 

166 



RESPONSIBILITY FOR ACCOUNTING: A SUMMING UP 

have been machinery for a thorough and independent examina- 
tion of all aspects of a problem followed by an authoritative 
decision. Whether the particular machinery suggested here is 
the most suitable is subject to further debate. That there must 
be some such machinery is not. Changes in our business society 
are taking place far too rapidly and the number of unresolved 
accounting problems created by these changes is far too nu- 
merous to permit a continuation of an interminable and dis- 
orderly evolution away from the standards of an earlier and 
much different time. 



IV 

"Accounting seems to flourish in a stable environment, and 
to languish in an unstable one. Flux, change and disorder are 
always unsettling." These words of Maurice Moonitz, director 
of research of the AICPA 7 form a most succinct statement of a 
fundamental problem of accounting. It seems inevitable that we 
will continue to be unsettled since flux, change, and disorder are 
surely the signs of our time. A principal task of accounting is to 
accept the uncertainty which is their progeny. 

Most currently accepted accounting concepts and procedures 
are based on an expectation of certainty of a sort. Historical 
cost can be verified; therefore it is certain. Realization can be 
verified and thus is a certain thing. This dependence upon veri- 
fication is undoubtedly related to the public accountant's or 
auditor's traditional function of checking up, of attempting to 
ascertain that neither theft nor fraud has taken place. Verification 
obviously is the basis of such activity. This sort of checking up 
is still an important function, for there is no evidence that the 
thieves and defrauders among us have become fewer. It is equally 
important, however, that concepts and procedures appropriate 
to this policeman function cease to influence that more significant 
function of accounting which is to provide a basis for communi- 
cation between corporations and their several constituencies. 



7 American Institute of Certified Public Accountants, The Basic Postulates 
of Accounting (Accounting Research Study No. 1) (New York, 1961), p. 9. 

167 



Contemporary Corporate Accounting and the Public 

Meeting this need requires the best possible statement of the 
current status and probable future progress of the corporation, 
which, in a period of flux, change, and disorder, are manifestly 
not measured by past events no matter how precisely they may 
be verified. 

It has often been said in defense of accounting practice that 
the reader of a financial statement knows he is reading verifiable 
facts and not someone's approximation and guesses. The implica- 
tion is that he is therefore better off. But if these verifiable facts 
are of little relevance to the judgments and decisions he has to 
make it is hard to see how he is any better off than the explorer 
planning an expedition from Little America towards the South 
Pole with forecasts of weather in Labrador. 

Accountants seem to regularly underestimate their own and 
management's intelligence. Managements regularly base deci- 
sions on best estimates of current and probable future values- 
decisions which in the aggregate involve billions of dollars an- 
nually. Those who must evaluate these decisions have a need 
for access to the same relevant information. Nor does this call 
for fortunetelling. Replacement value cannot always be verified 
in the way historical cost can be read from an invoice, but it 
can be estimated quite closely. Manufacturing know-how cannot 
be walked about in as can manufacturing facilities, but its ex- 
istence is generally obvious from the sale of the corporation's 
products. Investors make valuations of corporations every minute 
of the day, utilizing far less information than managers and their 
public accountants have as a matter of course. 

Ultimately the issue is certainty versus relevance; the pica- 
yune versus the significant. Accounting should be willing to 
substitute business and economic intelligence and good judgment 
for routine verification. The accountant must temper the impor- 
tance of precedent in his activities with an acceptance of and 
accommodation to change. Only by accepting a broader and 
more challenging view of its role of furnishing relevant and sig- 
nificant data to the constituencies of the corporation can ac- 
counting meet its obligation to the society which is so dominated 
by the corporation. 

168 



RESPONSIBILITY FOR ACCOUNTING: A SUMMING UP 



In concluding both chapter and book, two important im- 
plications of much written here should be pointed out. 

First, a number of suggestions made involve substantial 
departures from current accounting practice and some of them 
will not be easy to implement. Indeed, some of them may have 
to be modified after trial. However, the fact that there are few 
precedents for some of these suggestions is not important. In an 
era when most of society's precedents are disappearing into 
outer space, it seems important to try any approach which will 
bring the practice of accounting more closely into accord with 
the changing social and economic role and objectives of the 
large corporations for which it is accounting. 

Second, many of the suggestions made in this book involve 
some additional interference in what have traditionally been the 
exclusive affairs of corporations— some further curtailment of 
their freedom. The need for this seems clear. The modern large 
corporation has an important influence on the lives of us all. It 
has a broad social responsibility which has been accepted by the 
great majority of corporation managers. A part of responsibility 
is periodic evaluation by those to whom one is responsible. In 
this sense, responsibility involves some loss of freedom, but it 
is quite in accord with our ideas and ideals that responsibility is 
an important guarantee of freedom. 



169 



w 



INDEX 



Accounting 

as control system, 14 
limited to financial matters, 38-39 
role of, 14-17 
uncertainty in, 167-68 
Accounting conventions; see also 
each convention 
development of, 31, 40-41 
reluctance to change, 31-32 
subjective origins of, 40 
Accounting Court, 166-67 
Accounting profession 
described, 161-63 

need for discipline and authority, 
165-66 
Accounting Research Bulletins 
Number 43, 136 
Number 47, 130 
Number 48, 120 
American Accounting Association, 
34,161 
Committee on Concepts and 
Standards, 34 
American Institute of Certified Public 
Accountants, 24, 26, 29, 34, 86, 
162 
Committee on Accounting 
Research, 31 
American Telephone and Telegraph 

Company, 3, 107, 116 
Armstrong Cork Company, 36 
Avco Corporation, 106, 108 

B 

Balance sheet defined, 23 

as source of information about 
growth, 23-24 
Berle, A. A., Jr., 2, 9 
Blough, Carmen, 35 
British-American Oil Co., Ltd., 103 
Brown, Louis D., 12, 13, 141 

C 

Capital, bases for valuation of; see 
Concepts of value and capital 

Capital gains, 59, 72 

Changing price levels; see Price-level 
adjustments 



Charitable contributions, 22, 62 
Chrysler Corporation, 34 
Comparability in accounting, need 

for, 26-33 
Compensation, accounting for, 123-41 
Complex business organizations 
forms of, 106-7 
need for information about 

components, 107-10 
need for information about entity, 
110-14 
Concepts of value and capital 
competitive-capacity, 60-61 
monetary, 52-53, 72 
present worth, 51-52, 79, 153-56 
productive-capacity, 54-55, 61, 72 
purchasing power, 53-54 
Conservatism, convention of, 40, 146, 

149, 156 
Consistency, convention of, 41 
Consolidated financial statements 
conditions for, 114-17 
defined, 114 

treatment of goodwill arising from, 
117-19 
Consumer Price Index; see Price- 
level adjustments 
Contractual intangible resources, 

143-44, 147 
Control, accounting information 

needed for, 15-16 
Corporations 

objectives of, 18-23 
responsibilities of, 11-13, 21-22 
role of managers of, 3, 140-41 
Cybernetic revolution, 10 



Dean, Joel, 149 

Decline in value of fixed assets 

pattern of decline, 84-85 

recognition of, in accounting, 86-92 

useful life, 83-84 
Declining-balance depreciation, 89-90 
Deferred compensation of executives, 

disclosure of, 140-41 
Deferred income taxes, accounting 
for, 94-98 



171 



INDEX 



Depletion, 102 

Depreciation, methods of accounting 
for 
constant deductions, 87-88 
decreasing deductions, 89-91 
variable deductions, 88-89 
"Direct costing," 73-76 
relationship with replacement cost, 
75-76 ' 
Disclosure of accounting methods, 

28-29 
Discrimination in accounting for 

intangible resources, 149-51 
Drucker, Peter, 132, 134 
Du Pont Company, 112 

E 

Eaton, Marquis, 26, 29 

Eisenhower, D wight D., 9 

Electronic data processing 
and corporate growth, 19 
in fixed-asset accounting, 82-83 
in inventory accounting, 71-72 

F 

FIFO inventory valuation; see In- 
ventory valuation methods 
Financial Executives Institute, 161 
Fixed-asset accounting, objectives of, 
78, 92-94; see also Depreciation, 
methods of accounting for 
Fixed assets, useful life of, 83-84 
Ford, Henry II, 131-32, 133, 134 
Funds statement 
place in corporate reports, 24 
as source of information about 
growth, 23-24 

G 

Galbraith, J. K., 19, 20 

General Dynamics Corporation, 56, 

152 
General Electric Company, 44, 56 
General Foods Corporation, 56 
General Mills, 56 
General Motors Corporation, 3, 56, 

107, 108-9, 112, 116 
Gilbert, Lewis D., 11 
Goodwill 

arising from consolidation, 117-19, 
148 

defined, 143-44 
Griswold, Erwin, 134 
Growth as corporate objective, 18-23 
Gulf Oil Corporation, 103 



Hendricksen, E. S., 36 
Holding company statements, limited 
value of, 112-14 



Imperial Tobacco Company of 

Canada, Ltd., 32, 82 
Income 

as corporate objective, 2, 18 
determination of, 18 
realized and unrealized, 58, 72, 80, 
104, 156 
Income taxation and accounting 
for fixed assets, 78 

deferred taxes, 94-98 
for intangible resources, 148 
for LIFO inventories, 69-70 
for pension plans, 127 
for stock options, 132-33 
Income taxation, influence of on 

accounting, 45-46 
Institute of Internal Auditors, 161 
Intangible resources 

discrimination in accounting for, 

149-51 
ignored in financial statements, 39 
in income determination, 147-48 
methods for valuation, 151-56 
uncertainty surrounding, 156-57 
Interstate Commerce Commission, 

29, 30, 162 
Inventory accounting; see also In- 
ventory valuation methods 
conflict between income and 

resource valuation, 64 
defined, 63 

"lower of cost or market," 72-73 
Inventory valuation methods 
average cost, 68 
FIFO, 65-68, 70-73 
LIFO, 61, 68-73 

and income taxation, 69-70 
replacement costs, 70-72 
specific identification, 65 



Jones, Ralph C, 35, 36 



Leased fixed assets, 98-101 
and replacement value, 101 



172 



INDEX 



LIFO inventory valuation; see In- 
ventory valuation methods 

Liquidation and sale of business 
distinguished, 44 

Livingston, J. A., 131-32 

M 

Management 

authority over accounting, 163-65 

compensation, 140-41 

relationship with corporation, 3, 13 
Materiality, convention of, 41 
Maximization of profits, 2, 20-21 
Mergers, accounting for, 119-22 
Merrill Foundation, 35 
Minnesota Mining and Manufacturing 

Company, 142 
Monetary concept of value; see 

Concepts of value and capital 
Money, role of in accounting, 42-43 
Moonitz, Maurice, 18, 35, 83, 167 

N 

National Association of Accountants, 

161 
Natural resources, 102-4 



Pension plans 

accounting for, 124-31 
basic characteristics of, 125-28 
past service benefits, 126, 128-30 
tax aspects, 127 
Permanence, convention of, 43, 55-56 
Pooling of interests, accounting for, 

120-22 
Present worth as basis for asset valu- 
ation; see Concepts of value and 
capital 
Price-level adjustments 

arguments for and against, 34-36 
procedures, 53-54 
relationship to replacement cost, 
56-57, 71, 83 
Productive-capacity concept of 

value; see Concepts of value and 
capital 
Promotional expenditures, 63, 142-43; 

see also Intangible resources 
Purchasing-power adjustments; see 

Price-level adjustments 
Purchasing-power concept of value; 
see Concepts of value and capital 



Replacement cost 
in accounting for 
fixed assets, 79-81 
inventories, 70-72 
natural resources, 102 
contrasted with adjusted historical 

cost, 56-58 
determination of, 54, 71, 79-83 
frequency of adjustment to, 71-72, 
82-83 
Research and development costs, 62, 
142-43; see also Intangible 
resources 



Securities and Exchange Commission, 

162, 164, 165 
Spacek, Leonard, 159, 160, 163, 166 
Sprouse, Robert, 83 
Stock options 

accounting for, 136-40 

annual income deductions, 138-39 

characteristics of, 132-33 

cost of, 133-36 

tax aspects, 132-33 
Stockholders, declining influence of, 

2, 12-13,21, 107, 123 
Straight-line depreciation, 87 
Sum-of-years-digits depreciation, 90 



Taxes; see Income taxation and 



accounting 
Travelers' Insurance Co. 



U 



44 



Uncertainty, reactions to, 156, 167-68 
Uniform System of Accounts for 

Class I Railroads, 30 
Uniformity in accounting, 26-33 

enforced, 29-31 
United States Steel Corporation, 

3, 34, 44, 60, 106 
Unrealized income, 58, 72, 80, 104, 156 
User depreciation methods, 88-89 



Valuation of capital; see Concepts of 

value and capital 
Valuation of resources; see Concepts 

of value and capital 



173 



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